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IntroductionHealth-care costs and health insurance are always in the news. These expenditures have become more evident as medical treatments and drug therapies improve and as health care becomes a bigger part of the U. S. gross domestic product.
The cost of health-care accounts for an increasingly larger part of the U. S. economy. Each year, health-related spending escalates, often outpacing spending on other goods and services. These cost increases have a considerable effect on the way households, businesses, and government agencies operate. Among other things, inflation associated with health-care costs places extreme pressure on businesses that offer insurance benefits to their employees. It also discourages individuals from purchasing their own coverage, can be an immense financial burden to families, and consumes an ever-increasing share of taxpayer dollars and government budgets.
Consider these startling facts about the cost of health care:
In 2010, the U.S. spent $2.6 trillion on health care, an average of $8,402 per person.1
The share of economic activity (gross domestic product, or GDP) devoted to health care rose to 17.9 percent in 2010.
Health-care costs have grown on average 2.4 percentage points faster than the U.S. gross domestic product since 1970.2
In 1970, total health-care spending was about $75 billion, or only about $356 per person.3
Many industry experts believe that new technologies and the spread of existing technologies account for a large portion of medical spending and its growth. The Centers for Medicare and Medicaid Services (CMS) projects that health spending will be nearly one-fifth of the gross domestic product (19.8 percent) by the year 2020.4
Course ObjectivesThis course reviews the ways in which health and accident insurance can be used to meet the costs of health care. The purpose of this course is to provide a thorough understanding of the sources from which most people obtain their health insurance—from employers, by individually contracting with insurance companies, by securing coverage through groups, and from the government. We will study the regulation of health insurance and some of the tax aspects pertaining to paying for and receiving benefits. We will focus on the features of private insurance plans as well as the benefits of social programs. We will examine the concept of managed care as a means of containing health-care costs. The course also explores disability insurance and long-term care coverage. Also included is an overview of the 2010 Patient Protection and Affordable Care Act (PPACA), as well as specific provisions of this act.
Upon conclusion of this course, you should
understand private medical insurance and the ways in which traditional fee-for-service arrangements have been used to pay for health care;
be able to characterize the managed care model as a means delivering health care more efficiently;
be familiar with disability policies and be able to distinguish between types of coverages;
understand the concept of long-term care and how partnership policies can reduce Medicaid’s burden of paying LTC costs;
describe accidental death and dismemberment insurance coverage;
know some of the state and federal rules that govern health insurance;
understand the four parts of Medicare and their roles in providing health-care benefits for participants; understand the scope of coverage of other government insurance programs such as Medicaid, Social Security, and workers’ compensation; and
understand how the implementation of health-care reforms passed with the PPACA alter health insurance benefits and the financing and administration of health insurance going forward.
Also, the following icon is used throughout the course and represents a note. Notes help to clarify information or help to further illustrate a particular concept or point:
1Heath Care Costs: A Primer. Key Information on Health Care Costs and Their Impact, by the Henry J. Kaiser Family Foundation, May 2010.
2 Ibid.
3 Ibid.
4 U.S. Department of Health and Human Services, Centers for Medicare and Medicaid Services, “National Health Expenditure Projections 2010 – 2020.”
1.1 - Sources of Health InsuranceAn individual may receive health insurance coverage from a number of sources:
through employment, where the employer or a union provides the coverage;
through a group or organization;
by individually contracting with an insurance company; and
from the federal or state government in the form of Medicare, Medicaid, Social Security disability benefits, and workers’ compensation.
This chapter describes employer-provided, group, and individually contracted insurance. Government-provided disability benefits are discussed in Chapter 6.
Upon conclusion of this chapter, you should be able to
explain how employer-provided health insurance benefits both employers and employees;
describe the characteristics of group health insurance plans;
explain self-insurance and multiple insurance trusts as alternatives to traditional health insurance plans; and
describe individual health insurance policies.
1.2 - Employer-Provided Health InsuranceAlthough a few employers offered some form of health care before World War II, often in the form of the company infirmary, only after the United States entered this war did employers begin to systematically offer health insurance as an employment benefit. The federal government had imposed a wartime freeze on salaries, so employers could not court workers by offering them higher wages. However, employers could and did promise better benefit packages. At that time, health insurance was reasonably inexpensive. Employees also received a tax break. They did not have to treat the health insurance benefits as taxable wages, either at the time a premium was paid on their behalf or when they received benefits under the plan.
The addition of health insurance as an employee benefit offered the following advantages:
The benefits were not counted as wages for purposes of the freeze.
Coverage was relatively inexpensive, less than individual coverage.
Benefits paid on behalf of employees were tax-deductible to the employer.
Employees suffered no tax consequences.
Employers provided health benefits primarily in one of two ways:
by contributing to a health plan maintained by a union covering the employer’s workers; or
by contracting with a commercial insurer to provide group coverage to employees.
Union Benefit PlansUnion benefit plans are generally provided by a fund that the union maintains and administers. The benefits are often portable in that a worker maintains eligibility so long as he or she continues in a job covered by a collective bargaining agreement, even if the worker moves from one employer to another. Benefits are also often continued into retirement. Group Insurance Plans
Where the employer contracts with a commercial insurer to provide health benefits, the coverage is usually provided under a group contract. Group policies, whether maintained by an employer or by an organization, are sold in the form of a singlemaster policy. The employer or group is the policyholder and exercises the rights of a policyholder, such as the right to receive notices and to switch to another plan of coverage. The individual participants in the plan are certificate holders. Certificate holders receive a certificate informing them of the terms of their coverage. What constitutes a group is defined by state insurance law, but it generally means at least two persons who have a common association that is not formed just for the purpose of obtaining insurance. So in addition to employees of a given employer, this definition can also include members of a union, professional association, alumni association, etc. While state law may grant group status to as few as two persons, insurers tend to differentiate among these groups depending upon their size, using different standards for groups from 2 to 10 members, 11 to 50 members, and so on. The larger the group, the more favorable the terms tend to be for underwriting, coverage limits, and premium rates. For example, an individual who wants to purchase medical insurance coverage may be required to provide detailed evidence of insurability, or even to submit to a physical examination, whereas a member of a small group may only have to complete a short medical questionnaire. Members of large groups are eligible simply by virtue of their membership in the group—no questions asked.
As to premiums, the rate for a larger group can be determined on an experience-rated basis, which means that the premiums are based on the anticipated claims experience just for that group as estimated from past claims experience. Individual and small group premiums are calculated in whole or in part on a manual or pooled rate, which takes into account the insurer’s entire pool of business. If a particular large employee group has anticipated claims experience that is better than the insurer’s coverage pool as a whole, then the group will be charged a lower premium based on the pooled rate. Other Methods of Providing InsuranceIn addition to providing coverage under a group contract, an employer has other ways to provide benefits to its employees without contracting directly with an insurance company, such as
bearing the coverage risk itself by self-insuring; or
joining a multiple employer trust.
These methods are discussed in the following sections. Self-InsuranceFor business and individuals, an alternative to a commercial or service health insurance plan is self-insurance. Large corporations frequently self-insure their sick-leave plans for their employees. Labor unions, fraternal associations, and other groups often self-insure their medical expense plans, funded through dues or contributions from members. Others may self-insure part of a plan and use stop-loss insurance from a commercial carrier to protect against large, unpredictable losses above a specified threshold amount. For example, an employer may establish a fund that anticipates paying out $200,000 in claims. In a year when claims are unusually heavy, say $500,000, the stop-loss coverage picks up the amounts in excess of $200,000.
Many of these self-insured plans are administered by insurance companies under an administrative services only (ASO) arrangement, or by other third-party administrators (TPAs) that are paid a fee for handling the paperwork and processing the claims. Multiple Employer TrustsThe multiple employer trust (MET) is a method that can be used to provide group benefits to employers who have a very small number of employees. A MET can be sponsored by a bank, an insurance company, or a third-party administrator. METs can provide a single type of insurance or a wide range of coverages. To obtain coverage for employees from a MET, an employer must first become a member of the trust by subscribing to it. After that, the employer is issued a joiner agreement, which describes the relationship between the trust and the employer and specifies the coverages to which the employer has subscribed.
The MET provides benefits in one of two ways: on a self-funded basis or with a contract. This contract is usually purchased from an insurance company. In this case and with the self-funded basis, the trust rather than the subscribing employers are provided with benefit descriptions in a way that is similar to the usual group insurance agreement.
(For the most part, self-funded plans and METs are untethered by the Patient Protection and Affordable Care Act. Multiple employer plans are subject to some reporting requirements to stem problems concerning fraudulent activity.)
1.3 - Individual Insurance
If employer-provided or group health insurance is not a viable alternative, an individual can apply directly to an insurance company for an individually issued policy. The advantage of individual coverage is that an individual can more or less dictate the type of benefits he or she wants.
There are also disadvantages, however:
The individual has to bear the full expense alone.
The individual must shop for coverage that is often more expensive and less comprehensive than that offered through group arrangements.
The policy must be underwritten, which means that the level of coverage, premium, and willingness of an insurer to issue the policy at all depends on the individual’s risk category—a function of the applicant’s health and medical history.
Individual policies are subject to regular premium increases that may make the cost prohibitive.
(The above describes the individual health insurance market that was in place prior to passage of the PPACA. As part of the PPACA, pre-existing condition exclusions have been eliminated for children aged 18 and younger for plans renewing after September 23, 2010. For adults, pre-existing condition exclusions will no longer be allowed after January 1, 2014. See below.)
Unfortunately, individual insurance policies are most readily available for the healthy. Many states have laws that ensure individuals who are undesirable risks from a health standpoint of the right to obtain some form of individual coverage. This coverage may be available through the state’s special risk pool, which provides coverage for those who cannot afford coverage or who may have a pre-existing condition precluding coverage. States find various ways to fund their risk pools, such as tax on hospital revenues. Still, the cost is likely to exceed that of a policy issued to a normal or preferred risk. Some states may phase out operation of their high-risk pools as individuals gain access to health insurance through the health insurance exchanges beginning in 2014.
1.4 - Patient Protection and Affordable Care Act of 2010In March 2010, the Patient Protection and Affordable Care Act (PPACA) was signed into law, marking significant and comprehensive changes in health-care delivery and health-care coverage. The intent of the law is to create a framework for expanded coverage, cost controls, and improved health-care delivery. The changes the PPACA brings about are many; some have already been put into effect, while others will become effective over the next few years. Though an in-depth discussion and analysis of these changes are beyond the scope of this course (and some provisions of the act remain in question as to whether they will be implemented), the most significant are covered here. To provide an orientation to the scope and extent of the PPACA, the major changes are summarized in the following chart. (This information derives from a 2011 Kaiser Foundation “Focus on Health Reform” summary report.5 ) Subsequent chapters also include discussion of the PPACA provisions as they pertain to specific topics or areas.
Effective dates for these provisions (and others not included in this summary) range from 2010 to 2018. Many of the changes become effective in 2014. A table showing the dates for implementation of specific provisions of the act is included in the Appendix. Overall Approach to Expanding Access to Coverage
Require most U.S. citizens and legal residents to have health insurance.
Create state-based health insurance benefit exchanges through which individuals can purchase coverage, with premium and cost-sharing credits available to low-income earners and families. Create separate exchanges through which small businesses can purchase coverage for their employees. Impose new regulations on health plans in the exchanges and in the individual and small group markets. Require employers to pay penalties for employees who receive tax credits for health insurance through an exchange (with some exceptions). Impose new regulations on health plans in the exchanges and in the individual and small group markets. Expand Medicaid coverage to 133 percent of the federal poverty level. INDIVIDUAL MANDATE Requirement to have coverage
Require most U.S. citizens and legal residents to have health coverage; those without coverage will pay a penalty (the amount of which will be phased in over three years, beginning in 2014).
Exemptions will be granted for certain circumstances, including financial hardship and religious objections. EMPLOYER RULES Requirements for coverage
Create different sets of rules, requirements, and obligations for employer-provided health insurance, based on employer size: small employers (fewer than 50 full-time workers); mid-size employers (50 to 100 workers); large employers (more than 100 workers).
Provide financial assistance (i.e., tax credits) to small employers to maintain or begin offering health coverage to their employees. Impose financial obligations on mid-size and large employers to maintain or offer minimum essential coverage to their employees by assessing penalties if one or more of their workers obtain subsidized coverage through the health insurance benefit exchanges. Allow employers with 50 to 100 workers to have the option to purchase coverage for their workers (and their dependents) through the new health insurance exchanges. These employers may retain the health insurance coverage they currently provide, under the act’s grandfather provisions, as long as the coverage meets certain minimum requirements. Large employers that offer group health insurance plans must automatically enroll new full-time employees in a plan and provide information about how the employee may opt out and receive coverage through an exchange. HEALTH INSURANCE EXCHANGES Creation of health insurance exchanges
Create state-based health insurance exchanges, administered by a governmental agency or nonprofit organization, through which individuals and small businesses with up to 100 employees can purchase qualified coverage.
Restrict access to coverage through the exchanges to U.S. citizens and legal immigrants. Create four benefit categories of plans (Bronze, Silver, Gold, Platinum) plus a separate catastrophic plan to be offered through the exchanges, for individuals and small groups. Insurance market and rating rules
Require guarantee issue and renewability.
Allow rating based only on age, premium rating area (geographic area), family composition, and tobacco use. Disallow rating based on medical and health history. Require qualified plans participating in an exchange to meet marketing requirements, have adequate provider networks, contract with essential community providers, and be accredited with respect to performance on quality measures. Premium and cost subsidies
Provide premium credits to eligible individuals and families with incomes between 133 and 400 percent of the federal poverty level to purchase insurance through the exchanges.
Provide cost-sharing subsidies to eligible individuals and families. Limit availability of premium credits and cost-sharing subsidies through the exchanges to U.S. citizens and legal immigrants who meet income limits. Employees who are offered coverage by an employer are generally not eligible for premium credits unless certain exceptions apply. ESSENTIAL BENEFITS COVERAGE Essential benefits package
Create an essential health benefits package that provides a comprehensive set of services, limits annual cost sharing to the current HSA limits, and is not more extensive than the typical employer plan.
Require all qualified health benefit plans, including those offered through the exchanges and those offered in the individual and group markets outside the exchanges, to offer at least the essential health benefits package. Some exemptions for grandfathered plans apply. CHANGES TO PRIVATE INSURANCE Insurance market rules
Establish a process for reviewing increases in health plan premiums and require plans to justify increases.
Require states to report on trends in premium increases and recommend whether certain plans should be excluded from exchanges based on unjustified premium increases. Create a national, temporary high-risk pool to provide health coverage for individuals with pre-existing medical conditions and who have been uninsured for at least six months; provide for subsidized premiums for those who qualify. Prohibit individual and group health plans from placing annual and lifetime limits on the dollar value of coverage. Prohibit insurers from rescinding coverage except in cases of fraud. Provide dependent coverage for children up to age 26 for all individual and group policies. Grandfather existing individual and group plans with respect to new benefit standards, but require such plans to extend dependent coverage to age 26 and prohibit rescissions of coverage. Require grandfathered group plans to eliminate annual and lifetime limits on coverage. Require all new policies (except stand-alone dental, vision, and long-term care insurance) to comply with one of the four benefit categories. Limit deductibles for small group health plans to certain amounts, unless contributions are offered that offset deductible amounts above these limits. Limit any waiting period for coverage to 90 days. EXPANSION OF PUBLIC PROGRAMS Treatment of Medicaid
Expand Medicaid to all non-Medicare-eligible individuals under age 65 with incomes up to 133 percent of the federal poverty level (FPL).
Guarantee all newly Medicaid-eligible individuals a benchmark benefits package that meets the essential health benefits available through the exchanges. TAX CHANGES RELATED TO HEALTH INSURANCE Tax changes
Impose a penalty on individuals without qualifying coverage.
Exclude nonprescription drugs from reimbursement through an HRA, FSA, HSA, or Archer MSA. Increase the tax on nonqualified distributions from an HSA or an Archer MSA to 20 percent. Limit contributions to an FSA for medical expenses to $2,500 a year, COLA-adjusted annually. Increase the threshold for the itemized medical expense income tax deduction from 7.5 percent of AGI to 10 percent of AGI (increase waived for seniors through 2016). Increase Medicare Part A wage tax for upper income earners “Focus on Health Reform: Summary of New Health Reform Law,” The Kaiser Foundation, April 2011. Perhaps the most momentous change the act brings about is the individual mandate. The PPACA intends that most people will have health insurance, whether through their employers, through private insurance coverage, or through a health insurance exchange. As the law now stands, individuals who do not purchase or have health insurance will be subject to an annual penalty. The penalty is the greater of a dollar amount or a percent of taxable income, phased in according to the following schedule: Year Dollar Amount Percent of Taxable Income 2014 $95 1.0% 2015 $325 2.0% 2016 $695 2.5% Beginning in 2017, the penalty will be increased annually by the cost-of-living adjustment factor. The penalty for a family choosing not to purchase health insurance will be no more than three times the individual penalty. As the law now stands, exemptions from the mandate will extend to certain persons and groups, based on income, religious objections, and the like.
5 “Focus on Health Reform: Summary of New Health Reform Law,” The Kaiser Foundation, April 2011.
1.5 - Chapter SummaryHealth insurance may be obtained individually or through employer-provided coverage, a group or organization, or state or federal government programs. Beginning in 2014, most individuals will be required to have health insurance or face a penalty. Individuals and small employer groups (those consisting of 100 or fewer employees) can obtain health insurance through new health insurance exchanges. Employer-provided coverage is a very lucrative benefit to workers and represents a tax deduction to employers. Eligible small employers (those with fewer than 25 full-time employees) may receive a credit for their employee health insurance expenses if coverage is purchased through an exchange. Groups, when they are not formed specifically for the purpose of obtaining insurance coverage, can provide their members with affordable coverages. These policies are written as a single master plan with members as certificate holders. Individual coverage is the most costly of these options and is currently underwritten based on the applicant’s health and medical history. However, the provisions of the PPACA stipulate that, as of 2014, pre-existing conditions cannot be used as underwriting criteria for individual policies. Also in 2014, individuals will be able to obtain health insurance coverage through a health insurance exchange.

<p><span>Introduction</span></p>
<p><span>The main priority for business owners and managers is the daily operation of their business. Such issues as sales, production, cost control, quality control, on-time delivery, customer services, employee relations, and other issues consume maximum time, mental concentration, and attention. As such, life insurance for businesses provides an invaluable benefit: it allows business owners and managers to focus on these primary concerns by managing risks and offering protection against a variety of anticipated and unexpected contingencies. For example, business insurance can protect against property and casualty losses, litigation, business interruption from natural causes, labor issues, disability, death, etc.</span></p>
<p><span>Business life insurance also ensures a successful continuation of the business and protects invested time and assets. Planning for the continuation of the business is always associated with how that business entity has been structured: is the business a sole proprietorship, a partnership, a corporation, or a limited liability company? The answer to this question dictates how the company manages risks in terms of human capital, or what will and may happen to the business, to the investors, to the employees, and to the families of the employees in the event of death. Prudent business owners and managers plan for these contingencies.</span></p>
<p><span>In light of these considerations, this course thoroughly analyzes the problems common to all of these business structures and compares the specific problems they encounter. This content is especially tailored for insurance agents, financial planners, advisors, CPAs, and other financial professionals who serve the business community as advisors.</span></p>
<p><span>The chapter summaries provided below identify the scope for this book and describe the type of information you can expect to find in each chapter:</span></p>
<p><span><strong>Chapter 1, Introduction to Business Insurance,</strong> identifies the advantages and disadvantages of the four types of business structures: sole proprietorships, partnerships, corporations, and limited liability companies.</span></p>
<p><span><strong>Chapter 2, The Sole Proprietorship,</strong> addresses specific liabilities for sole proprietorships, as well as their tax issues, factors for continuing a sole proprietorship, legal implications, and many other attributes that distinguish them from the other types of business structures.</span></p>
<p><span><strong>Chapter 3, The Partnership,</strong> identifies when and how a partnership is formed and explores the types of partnerships that can be established, the duties of partners, tax issues of partnerships, events occurring when a partner dies, and many other characteristics of partnerships.</span></p>
<p><span><strong>Chapter 4, The Corporation,</strong> describes the fundamental characteristics of corporations, including the ways in which a corporation is formed and approved, the types of corporations, property rights, liabilities, and the reasons for liquidating a corporation..</span></p>
<p><span><strong>Chapter 5, The Limited Liability Company,</strong> explains the tax implications for LLCs, the benefits in establishing a family LLC as opposed to a family limited partnership, and the LLC's effects on business planning.</span></p>
<p><span><strong>Chapter 6, Other Uses of Life Insurance in Business,</strong> discusses the advantages/disadvantages of key person insurance, split-dollar plans, Section 162 Executive Bonus plans, deferred compensation arrangements, and corporate-owned life insurance.</span></p>
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<div style="margin-left:auto;"><span>1.</span><span>1 - </span><span>Introduction to Business Insurance</span>
<p><span>A business enterprise can be operated or conducted under various structures, the selection of which the owner or owners must determine. Naturally, all forms of business structures have their own advantages and disadvantages. Therefore, it is important for the insurance or financial professional to understand the distinctions between the various business forms and the consequences of a particular business structure. This chapter introduces you to these four forms of business structures and describes their advantages and disadvantages.</span></p>
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<div><span>1.</span><span>2 - </span><span>Types of Business Structures</span>
<p><span>The four principal types of business structures are</span></p>
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<li><span>sole proprietorships,</span></li>
<li><span>partnerships,</span></li>
<li><span>corporations, and</span></li>
<li><span>limited liability companies.</span></li>
</ul>
<p><span>Selecting one of these forms of business is one of the first decisions a business owner or owners must make. Although this decision is usually based on advice or counsel from an attorney or a CPA, each legal structure must be carefully considered to determine which structure best suits the goals and objectives of a particular business venture and the goals and objectives of its owners. Let's examine the positive and negative aspects of each structure.</span></p>
<span>The Sole Proprietorship</span>
<p><span>The sole proprietorship is the simplest, most efficient, and flexible form of business enterprise. While it is not unusual for a business to start as a sole proprietorship and then later to develop into a partnership or corporation, the sole proprietorship is nonetheless the most prevailing form of small business organizations.</span></p>
<p><span>Sole proprietorships are owned by one individual, usually the business owner, who makes all of the business decisions. Easing this process is the fact that setting up a sole proprietorship does not require much formal organizational or legal procedures.</span></p>
<span>Advantages of the Sole Proprietorship</span>
<p><span>A sole proprietorship as a business structure has the following advantages:</span></p>
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<li><span><strong>simplicity</strong>—Establishing a sole proprietorship requires less formality and fewer legal requirements. It needs little government approval or formal organizational procedures. Further, sole proprietorships are not required to get a separate tax identification number or to file separate taxes.</span></li>
<li><span><strong>sole ownership of profits</strong>—The sole proprietor is not required to share profits with anyone. This is a unique advantage when comparing the sole proprietorship to the other business structures.</span></li>
<li><span><strong>flexibility</strong>—A sole proprietor and single owner is able to make decisions quickly and to respond swiftly to business needs. New opportunities and new areas of business can be quickly acted upon, unhampered by having to consult with others.</span></li>
<li><span><strong>freedom</strong>—The simplicity of the sole proprietorship allows relative freedom from bureaucracy, government control, and special taxation issues. The sole proprietor can schedule hours of business operations as well as personal time that best suits his or her needs and objectives.</span></li>
</ul>
<span>Disadvantages of the Sole Proprietorship</span>
<p><span>Disadvantages of the sole proprietorship as a business structure are the following:</span></p>
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<li><span><strong>liability</strong>—The sole proprietor has full responsibility and complete liability for all of the obligations of the business. This includes debt, payables, and judgments.</span></li>
<li><span><strong>losses</strong>—While the sole proprietor is entitled to all of the profits, he or she must also bear all of the losses. Profits and losses are usually cyclical, and the sole proprietor must prepare in years of profit for those years of losses.</span></li>
<li><span><strong>less available capital</strong>—As a rule, the sole proprietor has less available capital and options in which capital can be obtained. The sole proprietor is likely to experience some difficulty in establishing long term financing, which may be needed to expand his or her business. Personal credit history and personal assets are always at risk in securing capital needs.</span></li>
<li><span><strong>instability</strong>—Business succession planning for the continuation of the sole proprietorship at the death of the owner is severely limited. In fact, a sole proprietorship is usually terminated at the death of the owner. In addition, unexpected contingencies and external factors have much greater impact on this form of enterprise.</span></li>
<li><span><strong>tax benefits</strong>—The sole proprietor does not enjoy some of the tax benefits that a corporation form of enterprise does, especially in the area of employee benefit planning and advanced planning strategies.</span></li>
</ul>
<span>The Partnership</span>
<p><span>By definition of the Uniform Partnership Act (UPA), a partnership is "an association of two or more persons to carry on as co-owners of a business for profit." A partnership is a contractual relationship between the persons who have combined their property, talents, labor, and skills in an enterprise for the purpose of joint profit. The concept of a partnership is very broad-it can be a syndicate, pool, joint venture, or other unincorporated organization through which any business is conducted, as long as it is not a corporation, a trust, or a sole proprietorship.</span></p>
<p><span>Following are some of the specific characteristics of a partnership.</span></p>
<span>Partnership Characteristics</span>
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<li><span>The partnership's formation requires the participation of two or more competent parties.</span></li>
<li><span>The partnership is an unincorporated association of persons, as distinguished from a corporation.</span></li>
<li><span>The partnership is established by the voluntary contract of the parties, as distinguished from a corporation, which is created by law.</span></li>
<li><span>The partnership's capital is established by contributions from each person's property, capital, talents, labor, or skill.</span></li>
<li><span>The partnership's business is transacted by the parties as principals, each of whom is a co-owner.</span></li>
<li><span>The partnership's purpose is to "carry on" a business for the monetary gain of the members, as distinguished from charitable, educational, religious, social, or other similar purposes.</span></li>
<li><span>The partnership can have general partners, limited partners, or family partners.</span></li>
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<span>Advantages of the Partnership</span>
<p><span>The advantages to a partnership as a form of business entity are the following:</span></p>
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<li><span><strong>additional human resources</strong>—The success or failure of the partnership is not solely dependent on one single individual. The skill, talent, and labor of each partner contribute to the benefit of the partnership.</span></li>
<li><span><strong>ease of formation</strong>—Although the procedures for forming a partnership are slightly more extensive than that of forming a sole proprietorship, establishing the partnership requires less formalities and expenses when compared with the requirements for creating a corporation.</span></li>
<li><span><strong>additional sources of capital</strong>—The partnership depends on the resources of two or more individuals.</span></li>
<li><span><strong>flexibility</strong>—A partnership can be more flexible in the decision making process than a corporation.</span></li>
<li><span><strong>freedom</strong>—The partnership has relative freedom from government regulation and special taxation when compared to a corporation.</span></li>
<li><span><strong>sharing of losses</strong>—The individuals in the partnership can share losses incurred in the operation of the partnership.</span></li>
</ul>
<span>Disadvantages of the Partnership</span>
<p><span>The disadvantages to a partnership as a form of business entity are the following:</span></p>
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<li><span><strong>unlimited liability of at least one partner</strong>—A partner is responsible for the full amount of business debts, even though he or she may exceed that individual's total investment. This liability extends to all of the partner's assets, including home, auto, bank accounts, property, etc.</span></li>
<li><span><strong>instability</strong>—Eliminating a partner for any reason, voluntary or involuntary, including by death, automatically dissolves the partnership.</span></li>
<li><span><strong>funding</strong>—It is relatively difficult to obtain large sums of capital in a partnership, including long-term financing.</span></li>
<li><span><strong>binding</strong>—All of the partners are bound by the acts of the other partners.</span></li>
<li><span><strong>disposal</strong>—Disposing of the partnership interests can be difficult, especially if a specific arrangement for this purpose does not exist.</span></li>
</ul>
<span>The Corporation</span>
<p><span>A business can be operated in an unincorporated form, such as a sole proprietorship or a partnership, or the business can be operated in an incorporated form, such as a corporation. The corporation is the most complex of these three business forms, and is defined as "an artificial being, invisible, intangible, and existing only in contemplation of the law." A corporation is considered a distinct legal entity, that is, separate and apart from the individuals who own it.</span></p>
<span>Corporation Characteristics</span>
<p><span>A corporation can be characterized as "a group of one or more persons acting as a group and with vested personality by the policy of the law."</span></p>
<p><span>A unique feature of the corporation is its ability to exist for an indefinite time. Under most state statutes, a corporation must state its period of duration in its "Articles of Incorporation," but its duration can be stated as "perpetual." This is a distinct advantage over the sole proprietorship and partnership business forms. Moreover, a corporation cannot be terminated by any change, removal, or death of an owner stockholder.</span></p>
<p><span>A corporation is usually formed by the authority of the state government. Corporations that do business in more than one state must comply with each of the individual state laws, and these can vary considerably.</span></p>
<p><span>Additionally, corporations can be divided into two broad categories:</span></p>
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<ul>
<li><span><strong>public</strong>—A public corporation is a governmental body, for example, a state or political subdivision of a state.</span></li>
<li><span><strong>private</strong>—A private corporation is one that is created for commerce; it can have various characteristics of distinction with regard to stock or non-stock entities, religious, charitable, etc.</span></li>
</ul>
<p><span>Corporations can elect how they want to be treated tax-wise. For example, a corporation can elect to be a non-profit; a "C" corporation; or a "Subsection S" corporation, all of which dictate their own tax status.</span></p>
<span>Advantages of the Corporation</span>
<p><span>The advantages to a corporation as a form of business entity are the following:</span></p>
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<ul>
<li><span><strong>limited liability</strong>—Unless otherwise noted, the liability of the owner-stockholder is limited to his or her amount of investment. Liability can be extended in cases where the owner-stockholder exercises a guarantee to a corporate note or credit line, or in cases where the owner-stockholder may have participated in fraudulent activity.</span></li>
<li><span><strong>transfer of ownership</strong>—Ownership can be transferred without affecting the ongoing operation of the business.</span></li>
<li><span><strong>separate entity</strong>—A corporation has status and is recognized as a separate entity, separate from the stockholder owners.</span></li>
<li><span><strong>stability</strong>—A corporation is relatively permanent in the sense that it continues to exist and to conduct business in the event of disability, illness, death, or any other condition that could impact an owner-stockholder. This is not true of a sole proprietorship or a partnership form of business.</span></li>
<li><span><strong>ease of securing capital</strong>—A corporation can secure large amounts of capital by issuing stock and long-term bonds. Long-term financing can also be secured by taking advantage of corporate assets.</span></li>
<li><span><strong>centralization of management</strong>—Owner-stockholders have supervised control of centralized management when they hire officers and managers. Owner-stockholders can also serve as officers, managers, or both.</span></li>
<li><span><strong>the availability of expertise and skills</strong>-A corporation can rely upon the expertise and the skills of many people.</span></li>
</ul>
<span>Disadvantages of the Corporation</span>
<p><span>The disadvantages to a corporation as a form of business entity are the following:</span></p>
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<ul>
<li><span><strong>limitations</strong>—Some activities are limited by the corporation's charter and by various state laws.</span></li>
<li><span><strong>management</strong>—A corporation has a more complex management structure than that of a sole proprietorship or partnership. Management decisions must go through a structured process.</span></li>
<li><span><strong>manipulation</strong>—Minority stockholders can sometimes be exploited.</span></li>
<li><span><strong>regulation</strong>—Corporations are extensively regulated at the state and federal levels.</span></li>
<li><span><strong>expense</strong>—Forming and maintaining a corporation have greater expenses when compared with a sole proprietorship or a partnership.</span></li>
<li><span><strong>taxation</strong>—A corporation has more taxation oversight, in which corporate income or profit are income taxed, as well as individual salaries and dividends. Even under a Subsection S election, distributions of income in the form of profits and salaries must be treated with care.</span></li>
</ul>
<span>The Limited Liability Company (LLC)</span>
<p><span>The limited liability company was first established in 1977 in the State of Wyoming and is now adopted by statute in all 50 states and the District of Columbia. This form of business offers owners the limited liability advantage that the C corporation also offers. LLCs also offer tax and management advantages as offered with a partnership. Because the state statutes are not uniform, this business form is best suited for business activity that can be confined to one or two states.</span></p>
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<span>1.</span><span>3 - </span><span>Factors Influencing the Choice of Business Structure</span>
<p><span>The major factors that must be considered when determining the business structure to best suit the needs of a particular business are</span></p>
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<ul>
<li><span><strong>nature of business activity</strong>—The amount of risk and potential liability of the activity that the business will engage in.</span></li>
<li><span><strong>number of owners</strong>—A one-owner business can choose any of the business structures to set up business. However, if the business will have more than one owner, the sole proprietorship is not an option.</span></li>
<li><span><strong>capital needs</strong>—This factor is a major influence in selecting a business structure.</span></li>
<li><span><strong>ownership involvement</strong>—In selecting a business structure, the parties involved must consider in what capacity the owner(s) will be involved. Will the owners be passive and only provide working capital for an interest in ownership? Or will the owners be actively engaged in daily operations?</span></li>
<li><span><strong>size and complexity of business</strong>—Smaller, first-time businesses may begin as a sole proprietorship and then change to a partnership or corporation.</span></li>
<li><span><strong>tax bracket and income source of individual owners</strong>—New businesses may have losses in the early years of start-up. A review of these losses may be viewed by an owner as a positive inducement for taking the risk of a new business.</span></li>
<li><span><strong>federal and state income tax laws</strong>—Deciding on a business structure must consider current laws and the fact that these laws are continually changing. Certain business structures are more heavily impacted by these evolving tax laws.</span></li>
<li><span><strong>federal and state regulations</strong>—Business activity, which is to be confined to a local geographic area, may find an advantage in one form of business structure over another. A business activity that covers multiple states may prefer a different structure.</span></li>
</ul>
<p><span>As you can see, each type of business structure has its own set of concerns and implications for how a business operates. In the remaining chapters of the book, we will examine each type of business structure in detail.</span></p>
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<span>2.</span><span>1 - </span><span>The Sole Proprietorship</span>
<p><span>The sole proprietorship is the most common form of business structure. It is a one-owner unincorporated business that has specific liabilities, tax issues, factors for continuing the business, legal implications, and many other attributes distinguishing it from the other types of business structures. This chapter examines these attributes in detail. First, let’s consider how a sole proprietorship is formed.</span></p>
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<span>2.</span><span>2 - </span><span>How a Sole Proprietorship is Formed</span>
<p><span>A single owner who has the required components to operate a particular business forms the sole proprietorship. The owner must obtain any required licenses or permits; commonly the owner files the name of the business as a d/b/a, (Doing Business As:____). Filing regulations varies by state, but it is common for the name of the business to be filed with a local government office. The sole proprietorship is not required to obtain an income tax identification number (I.D. number), because all business profits and losses belong to the owner’s individual social security (income tax) number.</span></p>
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<span>2.</span><span>3 - </span><span>The Rights of a Sole Proprietor</span>
<p><span>Sole proprietors have the same rights of dominion and control over their business assets that they have over their personal assets. Business and personal assets are not separated, because sole proprietors can keep, use, destroy, sell, exchange, barter, or otherwise dispose of their property as they choose. The only exception is if these actions infringe on the rights of others or violate regulatory laws.</span></p>
<p><span>Further, establishing a sole proprietorship does not create any new property rights, consequences, or asset-ownership exchange. In a legal sense, the assets of the business remain the personal assets of the owner. Any changes made with respect to a sole proprietor’s personal property when he or she spends money for the purchase of inventory, premises, furniture, or other necessary business property, are economic or financial changes rather than legal changes of property rights.</span></p>
<p><span>The sole proprietor can establish how and when the business operates and when to be open or closed. Moreover, the sole proprietor determines his or her time off according to personal preferences or obligations, and determines the pay scale for any employees.</span></p>
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<span>2.</span><span>4 - </span><span>The Liabilities of a Sole Proprietor</span>
<p><span>Sole proprietors have many liabilities. They are personally liable for all the debts, taxes and liabilities of the business. This includes claims made against them, any claims made against employees acting within the course and scope of their employment, and any property claims made in regard to default of care and service. In addition, sole proprietors are personally liable for such things as business property leases, vehicles, lines of credit, installment debts, and any other expenses incurred in doing business. This liability belongs solely to the owner, is unlimited and unshared, and encumbers all of his or her assets.</span></p>
<p><span>In the event of the death of the sole proprietor, business liabilities and personal liabilities are the same. All property not expressly exempted by state statute can be used in the payments of all debts; business debts need not be paid from business assets, and personal debts need not be paid from personal assets. Any assets held in or attributed to the estate of the deceased sole proprietor, including that of life insurance proceeds by rights of policy ownership, are used to address all claims and liabilities.</span></p>
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<span>2.</span><span>5 - </span><span>Tax Issues of a Sole Proprietorship</span>
<p><span>In a sole proprietorship, the business does not pay taxes as an entity. Rather, the owner reports and pays taxes on the profits of the business on his or her own individual tax return. No other tax return is required. If the sole proprietor sells his or her business, the profits of the sale go directly to the sole proprietor.</span></p>
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<span>2.</span><span>6 - </span><span>The Termination of a Sole Proprietorship</span>
<p><span>The termination of a sole proprietorship can occur by a voluntary act or from causes beyond the control of the owner, such as retirement, bankruptcy, or death.</span></p>
<p><span>Sole proprietors can cease the operation of the business at any time. However, they must fulfill any outstanding commitments and must liquidate the assets of the business. They can also sell the business to someone else, to a partnership, or to a corporation. Sole proprietors can also acquire additional owners by forming a partnership or corporation.</span></p>
<p><span>In the event of the death of a sole proprietor, the sole proprietorship simply ends. It does not have a legal entity distinction separate from that of the proprietor as an individual. Sole proprietors who want their business to continue beyond death can leave the remaining assets to anyone they choose after discharging the debts and obligations of the business and personal estate. They can leave the assets to a beneficiary, who can do with the assets what he or she wishes, or they can choose to leave the business to a beneficiary with the stipulation that the business continue to operate as it had been operating.</span></p>
<span>Effects of Terminating a Sole Proprietorship</span>
<p><span>Some potential damaging effects of terminating the proprietorship upon the death of the proprietor are</span></p>
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<li><span><strong>effect on general economy</strong>—Business units such as proprietorships, partnerships, and corporations contribute to and sustain their communities. Whether the company is large or small, the economic strength of the community is weakened when a business goes out of business.</span></li>
<li><span><strong>employees</strong>—Most sole proprietorships have employees whose livelihoods depend on the business. When the business terminates, these jobs are destroyed, usually with financial loss to the employees, their families, and to the community.</span></li>
<li><span><strong>disruption of income to the family</strong>—The income of the sole proprietor depends on the profits of the business. This income provides for the proprietor’s living expenses and those of his or her family. In the event of death, this income abruptly ceases, except for the completion of any contractual obligations, which may need to be fulfilled by the proprietor’s personal representative. Further, profits no longer exist, and the flow of funds to the family is halted.</span></li>
<li><span><strong>shrinkage of assets</strong>—The personal representative has the duty to convert the assets of the estate into cash. In the event the deceased proprietor leaves a will, the personal representative must convert all personal property into cash, except for that which is specifically bequeathed or permitted by will or consented to by the heirs.</span></li>
<li><span>However, this duty, even though directed or permitted, can be accomplished only to a limited degree in many cases. A considerable amount of cash may be required to pay final expenses, taxes, executor’s fees, legal fees, probate charges, and personal and business debts. Often the personal representative must liquidate the assets of the business for cash, which usually results in severe losses. Accounts receivable typically cannot be fully collected. The forced sale of inventory is often made at reduced prices, and equipment is frequently sold at a great sacrifice. Rarely does a single buyer purchase the proprietorship business, thereby reducing these sacrificial losses. Only when the sole proprietor has established during his or her lifetime an effective plan for the continuation of his or her business can this devastation be avoided.</span></li>
</ul>
<p><span>With proper planning, the sole proprietor can create a plan for the continuation of his business, enabling him to pass along to his heirs the true value of what had been created.</span></p>
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<span>2.</span><span>7 - </span><span>The Death of a Sole Proprietor</span>
<p><span>The death of the sole proprietor creates an immediate problem in that business operations must cease entirely until the probate court appoints an administrator. Until that time, no one has the legal authority to act.</span></p>
<p><span>This sudden interruption of business continuity could become a costly period of time. Some probate courts promptly appoint a temporary administrator, giving him or her the authority to keep the proprietorship business in operation until the regular personal representative qualifies.</span></p>
<span>If the Proprietor Leaves a Will</span>
<p><span>If the proprietor leaves a valid will, his or her executor, administers the business property and obligations in accordance with the will’s terms. If the proprietor does not leave a will, an administrator is appointed to manage the affairs in accordance with applicable probate and intestate laws.</span></p>
<p><span>With or with out a will, the personal representative (executor or administrator) is required to</span></p>
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<li><span>take possession of and inventory all of the deceased proprietor’s property;</span></li>
<li><span>conserve the property;</span></li>
<li><span>convert the property into cash, excepting real property, property, property specifically bequeathed by will, and items the heirs agree to accept, unless these items are required for the payment of debts;</span></li>
<li><span>pay the debts and obligations of the deceased; and</span></li>
<li><span>distribute the remainder to those who are entitled to it.</span></li>
</ul>
<p><span>Exceptions to these rules are made under certain circumstances. Examples of such circumstances are:</span></p>
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<li><span>special will provisions of the business;</span></li>
<li><span>special statutes authorizing a limited continuation of the business beyond the owner’s death; and</span></li>
<li><span>a business continuation agreement.</span></li>
</ul>
<span>If the Proprietor Does Not Leave a Will</span>
<p><span>When a person dies, his or her property, including the person’s business, must be collected. After debts, taxes, and expenses are paid, the remaining assets are distributed to the deceased’s beneficiaries stipulated in the will. However, if the deceased has not prepared a will, or if a will is determined to be invalid, the state graciously makes a will for the deceased. In either of these cases, the deceased is said to have died “in testate.” The intestacy laws of the state in which the deceased was domiciled at the time of his or her death dictate how to distribute the person’s assets; provisions are made for the spouse, children, etc. Some states may show preference to the surviving spouse, while other states may show preference to minor children.</span></p>
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<span>2.</span><span>8 - </span><span>The Personal Representative</span>
<p><span>In most instances, when a person dies owning property of any value, including a business, it is necessary to appoint someone to administer the estate. This person, acting on behalf of the deceased, is called the personal representative. The personal representative can be an individual, a bank or trust company, an attorney, or a combination of any of these.</span></p>
<p><span>The title and the duties of the personal representative depend on the method by which this person is selected or appointed, which depends on the circumstances involved and specific state statutes. For example, if the deceased business owner does <strong>not </strong>leave a valid will, then the personal representative is appointed by the Probate Office or the Register of Wills Office in the state or county of the deceased’s residence; the state or county will have jurisdiction over the deceased’s estate. When the personal representative must be appointed, he or she is called an <strong>administrator</strong>. If the deceased business owner does have a valid will, then a person or an institution is specifically named to act on the deceased’s behalf. This named personal representative is known as the <strong>executor</strong>.</span></p>
<p><span>State statutes typically stipulate the person who can serve as the administrator for a person who dies in testate. Usually this person is the spouse or an adult child. If no one with a close relationship is available, the court can appoint someone unknown to the deceased and unfamiliar with his or her affairs. State statutes hold the personal representative to the standard of care of a “reasonable, prudent individual” under all circumstances.</span></p>
<p><span>In addition, the personal representative is required to perform all duties with discretion. He or she can hire others to do only ministerial duties, but the personal representative must act as a prudent person in both what he or she does and in whom he or she hires. In fact, the personal representative can be held accountable for hiring someone not suited for the job. Unfortunately, what seems prudent to the personal representative when performing his or her tasks is not always seen in the same light to the beneficiaries. The can cause problems for the estate as well as for the surviving business operations.</span></p>
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<span>2.</span><span>9 - </span><span>Probate Issues</span>
<p><span>Probate means, “to prove.” The probate process</span></p>
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<ul>
<li><span>is the legal activity of proving the validity of a will and the competence of the deceased to make that will;</span></li>
<li><span>refers to the procedure by which the personal representative is appointed to handle the affairs of the deceased;</span></li>
<li><span>refers to the entire process of settling an estate;</span></li>
<li><span>incorporates the legal process of changing ownership of assets that were in the name of the deceased to those who are to be the new owners of the assets according to the provisions of the will or state statutes.</span></li>
</ul>
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<span>2.</span><span>10 - </span><span>Ways to Transfer Property at Death</span>
<p><span>There are four ways to transfer property at death:</span></p>
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<ol>
<li><span>probate</span></li>
<li><span>a contractual arrangement, such as life insurance, where the promise involves a contractual provision for a named beneficiary upon death;</span></li>
<li><span>joint ownership, where upon the death of one of the joint owners, the jointly held property is passed on to the other joint owner;</span></li>
<li><span>a living trust where, during lifetime, assets are placed in the trust, with provisions of how the assets are to be administered for the benefit of the beneficiaries of the trust.</span></li>
</ol>
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<span>2.</span><span>11 - </span><span>Preplanning</span>
<p><span>Continuing or disposing of a sole-proprietorship as part of an estate has many complex issues. To help ease this burden and to give guidance to the personal representative, preplanning is essential. For example, the sole proprietor may have arranged to sell his or her business or may have created a business succession plan for new management. Because an active business is extremely difficult to administer, planning for the disposition of the business greatly simplifies the personal representative’s role.</span></p>
<p><span>One possibility of preplanning the disposition is to arrange for <strong>a buy and sell agreement</strong>. This agreement provides that upon the sole proprietor’s death, the buyer is obligated to purchase the business interest for a specified sum. The personal representative is then obligated to sell to the designated buyer the business interest for that specified amount. Under such an arrangement, the personal representative need only transfer the deceased’s business interest to the new owner.</span></p>
<p><span>Many other issues could arise after the death of a business owner, which also emphasize the importance of preplanning. For example, if the deceased has a valid will that provides for the business to be left to multiple beneficiaries, one of the beneficiaries may want to sell the business while the other does not. Or perhaps they all want to sell the business, but cannot agree on how to do it or cannot agree on the value of the business. Perhaps they want to operate the business, but disagree on how to proceed. If a business is to survive its owner or to provide the desired amount of cash and value to the estate, these issues must be discussed, resolved, and planned for during the lifetime of the sole proprietor as part of the business planning and estate planning process.</span></p>
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<span>2.</span><span>12 - </span><span>Continuation of the Business</span>
<p><span>Upon the death of a sole proprietor, it is unlikely that the business will be able to continue operating. However, someone must be responsible to handle or to terminate the work in progress, to pay outstanding bills and wages, to collect outstanding receivables, and to make other decisions that involve closing the business.</span></p>
<p><span>As previously mentioned, a business is one of the most difficult assets to administer in an estate. Following are some of the areas of difficulty that the personal representative must address:</span></p>
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<li><span><strong>emotional involvement</strong>—The emotional involvement of the family, employees, and customers does not lend itself to rational decision-making.</span></li>
<li><span><strong>lack of liquidity</strong>—Frequently, most of the assets are tied up in the business and cash is not available to pay expenses. In addition, credit cannot usually be extended, nor are temporary cash advances available.</span></li>
<li><span><strong>lack of marketability</strong>—Finding a viable market for the business upon the death of the sole proprietor is difficult. Business assets are generally depressed in value because of the restrictions of negotiation and time frames.</span></li>
<li><span><strong>lack of diversification</strong>—In a sole proprietorship, the business generally represents the largest asset of wealth or value in the estate.</span></li>
</ul>
<span>Continuing the Business without Authority</span>
<p><span>Upon the death of the sole proprietor, the personal representative immediately takes possession of the business assets. In some cases, the personal representative may decide to continue the operation for the benefit of the heirs or the estate without authority to do so.</span></p>
<p><span>The unauthorized continuation of a sole proprietorship business by a personal representative, especially one who is unfamiliar with the business, often results in reduced or lost estate values. The the personal representative is fully liable for these negative consequences.</span></p>
<p><span>In addition, the personal representative must make other decisions, such as whether to carry on the business (with authority to do so), to sell the business, which assets to hold or sell, what rate of return to seek on investments, and what the most prudent method is to handle all estate assets. These activities can generate complaints by heirs, and such complaints can escalate into lawsuits against the personal representative.</span></p>
<p><span>If the personal representative can be shown to have not acted reasonably or in the best interests of the estate, he or she can be held personally liable for any mistakes made in administering the deceased’s estate.</span></p>
<p><span>To make matters worse, determining whether a continuation is authorized is very difficult. For example, while personal representatives have the duty to conserve the estate’s assets, they are also penalized if they continue the business without authority; sometimes the heirs request that the personal representative continue the business and give their consent to this. However, such continuation is not considered “authorized.” Minor heirs can never consent, as they are legally incapable of giving their permission. However, if all of the heirs are of age, competent, and the consent is unanimous, then the personal representative can continue the business. If profits result, the obligation of the personal representative to turn the profits over to the heirs remains the same. However, if losses are sustained, the consenting heirs have surrendered their right to hold the personal representative liable.</span></p>
<p><span>Although the personal representative may be relieved of liability of losses to consenting heirs, he or she may still be personally liable for any obligations entered into on behalf of the business. If assets of the business are sufficient, the personal representative may use them to cover the obligations. However, if assets become exhausted, creditors could hold the personal representative liable.</span></p>
<p><span>Sometimes an heir without authority continues the business of the deceased. Even if the heir is acting in good faith and believes he or she is proceeding in the best interests of the estate, the personal representative, not the heir, is still liable for all debts of the business.</span></p>
<span>Continuing the Business with Authority</span>
<p><span>If the personal representative has obtained unanimous consent from the heirs of the estate to continue the business, then he or she is not held liable for any losses incurred while doing so.</span></p>
<p><span>In most states, authority can be granted to the personal representative to temporarily run a business. Continuation of the business under the authority of a state statute is likely to allow continuance for only as long as is necessary to finalize the affairs of the business. A written court order is the safest authority for continuing a business after the death of the sole proprietor, but it does not allow the business to be run indefinitely.</span></p>
<p><span>Some statutes allow for the continuation of a business for the purpose of its sale as a going concern during the normal period of estate administration. A few states permit an extension until the sale of the business is made, but there are qualifying guidelines. If the personal representative carries on the business beyond the term provided by the statutes, he is carrying on the business without authority and could be held liable for losses.</span></p>
<span>Paying Heirs and Creditors with Estate Assets</span>
<p><span>The next issue to examine is the priority of creditors over the heirs. Creditors of the estate are entitled to be paid out of the estate assets before the heirs are paid out of the same. To facilitate this, the personal representative must conserve the estate assets and apply them to the payment of creditor claims against the estate. If debts are unpaid to the creditors, the creditors of the continued business may hold the personal representative liable. However, when these creditors consent to the continuation of the business after the proprietor’s death, they are essentially consenting also to the creation of new debts. The estate creditors are allowing their claims to be subordinated to those of the new creditors.</span></p>
<span>Summarizing Continuation Plans</span>
<p><span>As this chapter has so far shown, the need and value of a business continuation plan is invaluable in the event of death for the owner of a sole proprietorship. The existence of a business continuation plan can help to avoid loss for the estate, the heirs, and the employees. In addition, the business continuation plan can provide for liquidity, control, and a smooth transition for the personal representative. No matter how capable and well intentioned the personal representative may be, a plan created and implemented by the business owner will function more effectively</span></p>
<p><span>Because closing a business immediately upon the death of its owner is not desirable or necessarily efficient, a plan must be in place for the continuation of the proprietorship and controllable options.</span></p>
<span>Use of Will Provisions for the Continuation of the Business</span>
<p><span>By the use of the sole proprietor’s will, he or she can authorize the continuance of the business for any of the following purposes:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span>to enable inventory of goods on hand to be sold in the ordinary course of trade instead of piecemeal (where goods auctioned or sold individually to bidders in a forced sale environment). This provision in the will authorizes the continuation of the business until the inventory, stock, or merchandise on hand can be disposed of in the ordinary course of the trade. This provision is necessary as the state statutes are exceedingly narrow regarding this issue. This provision also helps to minimize or even to avoid the losses that can follow the immediate closing of a business upon the death of the owner and the piecemeal selling of inventory. However, this provision does not create the most desirable option, because the value of both the good will and the going concern of the enterprise will be lost.</span></li>
<li><span>to afford the personal representative an opportunity to sell the business as a going concern during the normal period of estate administration. This provision directs the personal representative to continue the business until he or she can sell it as a going concern during the normal period of estate administration. While this provision is an improvement over the first option listed, it may still be unsatisfactory, because a buyer who is willing to offer an adequate price may not be found during the period of estate administration.</span></li>
<li><span>to enable the business to be sold as a going concern, regardless of whether an advantageous sale can be made during the normal period of estate administration. Sometimes the sole proprietor provides in his or her will for the continuation of the business by his or her personal representative “until the business can be advantageously sold as a going concern.” The problem with this approach is that if the sole proprietor has not made sufficient capital available to pay all taxes, administration expenses and debts, final expenses, and other estate-related costs, as well as those cash needs required due to the continuation of the business, the personal representative will have a difficult time continuing the operation of the business.</span></li>
</ul>
<p><span>Although life insurance can be used as a method of providing for these cash needs, this option should only be proposed if the sole proprietor is satisfied that no better options are available and if a personal representative is willing and competent to operate the business until it can be advantageously sold—the executor must be willing to run the business. Unfortunately, securing a competent personal representative is frequently difficult, because this person must step in at a moments notice and carry on a business that is the result of the particular abilities and personality of the deceased.</span></p>
<p><span>Even in the best of circumstances, the business may at risk of continuing at a loss. Experience and familiarity with the business operations do not eliminate that risk, because other numerous factors can affect a business that a personal representative may not be able to control.</span></p>
<p> </p>
<p> </p>
<ul>
<li><span>to keep the business in tact and to provide a source of income until a member of the family can take it over. The sole proprietor may want to leave his business to a child or children. Moreover, he or she could provide in his or her will that the personal representative continue the business until it can be turned over to the child or children. Many hazards are involved in such a provision.</span></li>
</ul>
<p><span>To enable the personal representative to hold the business assets in tact during the period of administration of the estate and to continue the business successfully, the sole proprietor must provide sufficient capital available to pay all taxes, administration expenses and debts, final expenses, and other estate-related costs, and must provide those cash needs required for the continuation of the business.</span></p>
<p><span>In addition to selecting a competent personal representative who is willing to stay on the job as an operating trustee, possibly over a period of years, the sole proprietor must also select a contingent trustee who is equally competent and is willing to step in without prior notice and continue the business in the event of the death, disqualification, or renunciation of the original executor.</span></p>
<p><span>In most situations of this type, the time between the death of the sole proprietor and the time when the business can be turned over to the designated child or children could be several years. Nonetheless, the personal representative must run the business successfully over a period of time to turn over anything of value. Further, the risk of business evolution and change must be contemplated when considering such a provision. These changes may render the business’s product or service inefficient or outdated.</span></p>
<p><span>Yet another hazard in making a will provision to continue a business until a relative can assume operations is that under the estate laws of most states, a surviving spouse is entitled to a specific minimum share of the deceased’s estate. If a lesser portion is given to the spouse in the will, the spouse can “elect against the will” to receive the full share of the estate, despite the provisions of the will. This right cannot be denied, unless the surviving spouse has formally waived the right.</span></p>
<p><span>For example, a sole proprietor with a wife, a son, and a daughter would probably not want to leave the business, which could represent the bulk of his estate, to his son at the expense of his wife and daughter. Even though this arrangement meets only the minimum requirements of the estate law, it could happen.</span></p>
<p><span>A better option is if this sole proprietor considered purchasing additional assets, such as life insurance, to equalize the allocation of estate assets. In most states, however, life insurance proceeds to a surviving spouse are not counted in calculating the minimum share of the deceased’s property to which the spouse is legally entitled. The surviving spouse must waive statutory rights as part of such a plan, or the insurance proceeds he or she stands to receive must be made payable to the sole proprietor’s estate.</span></p>
<p><span>A more elaborate arrangement could be added to the plan, including the creation of a living insurance trust. With a living insurance trust, an irrevocable life insurance trust (ILIT) is created and is executed immediately. The insurance policy is owned by and is payable to the trust, and the amount of the policy is equal to the value of the sole proprietorship business. In addition, a testamentary trust must be a part of the plan. The will provides for the continuation of the business by the executor under the testamentary trust until the child is ready to take over the business. Until that time, the net income from the business and from the insurance trust is paid to the members of the family according to the stipulations of the will and trust documents.</span></p>
<p><span>When the child is ready to take over the business, the trustee transfers it to him or her. At this point, the insurance trust can be terminated, with the funds divided between the surviving spouse and the other children, or the trust can be continued for their benefit. These documents must be drawn to include alternative provisions for disposing of the business in the event that</span></p>
<ul>
<li>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span>it cannot be operated profitably;</span></li>
<li><span>the child that was to receive the business dies; or</span></li>
<li><span>the child decides to pursue a different career.</span></li>
</ul>
</li>
</ul>
<p><span>By using suitable will provisions, an insurable sole proprietor can distribute equal values of the assets by purchasing an appropriate amount of life insurance while at the same time preserving the legacy of his or her business.</span></p>
<p><span>The success of such a plan ultimately depends upon the ability of the personal representative to conduct the business in a profitable manner between the time of death of the sole proprietor and the time when the heir(s) can assume the operations of the business. Unfortunately, sole proprietors often delegate this complex task to someone who lacks the necessary ability or experience. Even an otherwise competent person can prove to be an amateur in a particular business. A plan of this nature should only be entrusted to a professional trustee or to an individual who possesses the necessary qualifications and who is willing to assume the responsibility. Even when such a person can be found, he or she is subject to the personal risks of death and disability over time. To offset this risk, a professional corporate trustee can be used.</span></p>
<p> </p>
<p> </p>
<ul>
<li><span>to allow the personal representative to use his or her discretion in disposing of the business given the circumstances. By making such a provision in his or her will, the sole proprietor must carefully describe the assets that are held in the bequest. He or she must state whether the personal representative is to pay the business debts from these assets. Preferably, life insurance should be provided to pay these debtors, as well as other obligations of the estate.</span></li>
</ul>
<p><span>Moreover, the sole proprietor must make certain that this provision of his or her will cannot be circumvented by other beneficiaries of the estate. To satisfy the legal requirements of minimum estate share distribution, the sole proprietor should secure sufficient additional life insurance for his or her spouse. He or she must also make sure that creditors will not circumvent this provision of the will, which can erode estate assets if not properly documented and if proper life insurance funding is not provided.</span></p>
<p> </p>
<p> </p>
<span>2.</span><span>13 - </span><span>Disposing of the Business</span>
<p><span>Better solutions exist for disposing of the business in the event of the sole proprietor’s death. These solutions are the living trust and selling the business, which are described in the following sections.</span></p>
<span>Using a Living Trust</span>
<p><span>A revocable living trust document may be changed or revoked by the sole proprietor at any time. The agreement allows the sole proprietor, during his lifetime, to familiarize the trustee with the operations of the business. It has the added advantage of relieving the sole proprietor of some of the burdens of sole management.</span></p>
<p><span>However, if the arrangement is going to be in effect for any length of time, there may be difficulty in finding a trustee capable and willing. A corporate trust may be engaged, but these often require that the business be incorporated. Trustee fees are significant consideration, and a trustee may insist on very broad powers.</span></p>
<span>Selling the Business</span>
<p><span>Issues to consider when the sole proprietor decides to sell the business are the following:</span></p>
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<p> </p>
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<p> </p>
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<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span>What is the overall financial condition of the business?</span></li>
<li><span>What is the condition of the physical assets of the business, and do they need repair or replacement?</span></li>
<li><span>What are the current and potential liabilities of the business?</span></li>
<li><span>Can the direction of the business be controlled?</span></li>
<li><span>Can the business survive under someone else’s direction?</span></li>
<li><span>Is there reliable management, such as a manager or other employees, who can step in and replace the owner?</span></li>
<li><span>How is the value of the business impacted if the sole proprietor were no longer running the business?</span></li>
<li><span>Can the business be sold, and to whom, and at what price?</span></li>
<li><span>How will current economic conditions affect the price of the business?</span></li>
</ul>
<span>The Buy-Sell Agreement</span>
<p><span>Sole proprietors can arrange to sell their business from their estate to a designated buyer with a buy-sell agreement. A buy-sell agreement is a binding contract for the buyer to purchase the business as a “going concern” and is triggered upon the death of the sole proprietor or some other event, such as retirement, as stated in the agreement. Upon the death of the sole proprietor, the buy-sell agreement obligates the buyer to purchase the business from the estate, and requires the estate to sell the business to that buyer.</span></p>
<p><span>In this sense, a buy-sell agreement between a sole proprietor and the person who buy’s the business upon the sole proprietor’s death establishes a pre-arranged market for the business. To be valid, the buy-sell agreement must contain an agreed upon price or a definite formula for valuation. This formula is then applied at the time of the sole proprietor’s death to determine the price for the buy-sell agreement. Further, the agreement must ensure that the purchaser has the money to pay the price in full or nearly in full at the sole proprietor’s death.</span></p>
<p><span>Therefore, preplanning requires a search for a logical successor to the sole proprietorship business. When this person or entity is found, a buy-sell agreement can be arranged. Without a pre-arranged plan, the business that a sole proprietor has worked so hard to establish will likely close its doors, be exposed to losses, or suffer diminished value in the event of the sole proprietor’s death. In the due course of administering the estate, assets are typically sold for only a fraction of their former worth, when they were assets of a profitable and going concern. Even with the best of intentions, if the sole proprietor provides in his or her will for the continuance of the business until it can be sold as a going concern, problems are often encountered before a buyer can be located.</span></p>
<span>Benefits of the Buy-Sell Agreement</span>
<p><span>By using a buy-sell arrangement, the business continues uninterrupted, which benefits the buyer, the heirs of the estate, and the community. For example, through a buy-sell agreement, the buyer acquires the sole proprietorship as an actively operating business. When the buy-sell agreement is properly arranged, it includes financing the purchase price; the sole proprietor’s estate receives the full value of the business in cash. The buyer can therefore afford to pay its going concern value. Consequently, the deceased sole proprietor’s estate suffers no losses because of forced liquidation.</span></p>
<p><span>Upon the sale of the sole proprietorship, taxes are due, and the balance can be placed in investments that are suitable for the surviving spouse and children.</span></p>
<span>Parties to the Buy-Sell Agreement</span>
<p><span>The most likely place to begin looking for a prospective buyer for a sole proprietorship is among the current employees of the sole proprietorship. Typically, one or more individuals have the ability and ambition, are familiar with the business, and may have already wondered what would happen to them, their jobs, and their families in the event the owner dies. Perhaps an employee or employees would welcome the opportunity to become the successor to the business.</span></p>
<p><span>In the case of small business operations where the sole proprietor may not have an employee who is capable or willing to succeed him or her, the sole proprietor may have to search elsewhere to find such a person and bring this person into the business. Discussing such arrangements with other business owners may be advantageous for the sole proprietor in some circumstances. These potential buyers could be competitors, vendors, or businesses that see the benefit of expanding their products or services through such an arrangement.</span></p>
<p><span>Sometimes buy-sell agreements are arranged between family members. The Internal Revenue Service very closely scrutinizes these arrangements to determine if they are actually bona fide business agreements or whether they are simply designed to transfer ownership of the property to family members for less than a fair valuation. Legislation has been enacted to prevent these interfamily arrangements when they are designed to pass business wealth through artificially low price valuations, or through impractical terms in the agreement.</span></p>
<p><span>Generally, a buy-sell agreement carries no weight in setting the tax value for transfer tax purposes between family members. For a buy-sell arrangement to qualify as a bona fide agreement between family members, the IRS specifies the following three requirements:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span>The agreement must be part of a bona fide business arrangement.</span></li>
<li><span>The agreement must not be a device to transfer the property to members of the deceased’s family for less than full and adequate consideration in money.</span></li>
<li><span>The terms of the agreement must be comparable to similar arrangements entered into by persons in other transactions. This is sometimes referred to as an “at arms length” transaction.</span></li>
</ol>
<span>Contents of the Buy-Sell Agreement</span>
<p><span>A competent attorney must create the buy-sell agreement, which has the following three elements:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span>The sole proprietor binds his or her estate to sell the enterprise to the purchaser upon the sole proprietor’s death. Likewise, the purchaser binds himself or herself to buy the business upon the death of the sole proprietor.</span></li>
<li><span>A life insurance policy is described as part of the agreement. The amount of the death benefit represents the predetermined value of the business.</span></li>
<li><span>The sole proprietor binds himself or herself to provide a “first right of refusal” to the purchaser should the sole proprietor determine to sell his or her business while living. This event may be triggered by illness, disability, or retirement. The arrangement for purchase can be negotiated or established, and can include terms of financing or payments. This provision is designed to protect the purchaser.</span></li>
</ol>
<p><span>Naturally, no two agreements for the purchase and sale of a sole proprietorship are exactly alike. However, in addition to the three elements stated previously, some common components of an agreement are</span></p>
<p> </p>
<p> </p>
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<p> </p>
<ul>
<li><span>a specific formula for valuating the business at the time of the sole proprietor’s death;</span></li>
<li><span>an agreement concerning the assets and liabilities of the business;</span></li>
<li><span>the purchaser’s commitment to purchase and maintain life insurance on the life of the sole proprietor to finance the purchase of the business;</span></li>
<li><span>a commitment that the purchaser will assume all business debts, or a portion thereof;</span></li>
<li><span>a provision for the ownership and control of the life insurance policy;</span></li>
<li><span>a commitment for the time and manner of paying any balance of the purchase price that exceeds the amount of the insurance proceeds, and a commitment to dispose of any insurance proceeds that exceed the purchase price. Both provisions anticipate a possible change in the price of the business upon valuation by formula;</span></li>
<li><span>a provision for disposal of the life insurance policy if the agreement is terminated during the lifetime of the parties or upon the death of the purchaser;</span></li>
<li><span>a granting of power of attorney to the purchaser by the sole proprietor to continue the business without interruption; and</span></li>
<li><span>provisions for altering, amending, or terminating the agreement.</span></li>
</ul>
<span>Validity of the Buy-Sell Agreement</span>
<p><span>Courts compel performance of the buy-sell agreement. For example, the parties are required to purchase and sell the business when a buy-sell contract is in force according to the terms of the contract; the non-performing party cannot simply pay a judgment for monetary damages for breach of contract.</span></p>
<span>Financing the Buy-Sell Agreement</span>
<p><span>The purchaser can carry life insurance on the life of the sole proprietor in the amount of the purchase price of the business. This assures all parties of the agreement that the cash needed to fulfill the obligations will be available when needed. Life insurance is also the most convenient and practical method of financing the purchase. Other methods of financing the business are not as practical or efficient. For example, rarely does an employee or a prospective buyer have the sufficient capital to pay cash for the business at the exact time of the sole proprietor’s death. Excluding the use of life insurance, the following three other methods are often used to finance the purchase of the business:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span>using savings to pay the purchase price;</span></li>
<li><span>paying the purchase price in installments over time after the death of the sole proprietor;</span></li>
<li><span>borrowing the money at the time of death of the sole proprietor.</span></li>
</ol>
<p><span>The obvious problem with using savings to pay for the purchase price is that the time of death of the sole proprietor is an unknown. Because death is an uncontrolled event, the buyer has no guarantee that the required funds will be available when needed.</span></p>
<p><span>Through life insurance, the premium payments become a method of saving for the purchase price. The advantage is that an untimely death is unlikely to occur and to disrupt the savings process. The effect of this type of financing arrangement is essentially to establish an advance installment plan to pay for the purchase price. The premiums can be semi-annual, quarterly, or even monthly payments. These installment payments stop at the death of the sole proprietor, when the financing plan becomes completed.</span></p>
<p><span>Using this advanced method of financing the purchase price compound interest favors the purchaser, because he or she is purchasing, in effect, a large capital asset of death benefit proceeds for pennies on the dollar. Conversely, using a purchase arrangement sometimes calls for installment payments after the sole proprietor dies; this arrangement has compound interest essentially working against the purchaser. The purchaser is, in effect, paying more than the purchase price of the business because of the added interest in the installment agreement.</span></p>
<p><span>Installment arrangements also jeopardize the estate, because making installment payments on the estate depends on the capability of the new business owner to continue the business profitably. This prospect is even more difficult, because the purchaser has increased his or her expenditures with the new debt obligation of these payments.</span></p>
<p><span>The only completely satisfactory method of financing the buy-sell agreement is when the purchaser carries life insurance on the life of the sole proprietor. This arrangement guarantees that the sole proprietor’s estate receives the full value for the business in cash upon the death of the sole proprietor. From the sole proprietor’s perspective, an enormously complex estate problem has been solved. From the purchaser’s perspective, upon the death of the sole proprietor, the purchase price is due. This automatically cancels all future installment payments and places the required funds into the purchaser’s hands.</span></p>
<span>Benefits of the Insured Buy-Sell Agreement</span>
<p><span>Financing a buy-sell agreement with life insurance has many benefits for all parties involved. First, for the purchaser, the future capital requirements are ensured. If the purchaser is an employee or group of employees, funding the buy-sell agreement with life insurance ensures that the business continues operations, that the employees have a job, and that the purchaser has ownership of a going business.</span></p>
<p><span>Although the primary objectives of an insured buy-sell agreement are realized at the death of the sole proprietor, the following are other advantages that emerge during the sole proprietor’s lifetime:</span></p>
<p> </p>
<p><strong>corporation</strong></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span><strong>Business is stabilized. </strong>Because the future of the sole proprietorship has been addressed, customers and vendors may be more readily obtained and retained. Conditions for establishing vendor and operational credit lines will be more favorable. Moreover, employees are likely to feel more secure and to contribute at a higher level to a stable organization. All these features can add profitability to existing business operations.</span></li>
<li><span><strong>A savings medium provided to the purchaser. </strong>Each premium payment represents an investment immediately put to work for the purchaser at compound interest. The life insurance has a cash value component that increases with each premium paid.</span></li>
<li><span><strong>The sole proprietor’s burden is relieved. </strong>If the purchaser in the buy-sell agreement is an employee or group of employees, they will be more unlikely to leave the business or to establish a competing business. Further, they will likely be more eager to assume additional responsibilities in the operations of the business. This allows the sole proprietor to focus on other business-related matters or to slow down in his or her business activities without sacrificing business responsibilities.</span></li>
</ul>
<p><span>Benefits for the <strong>heirs </strong>of the estate are the following:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span><strong>The estate receives payment for the full value of the sole proprietorship.</strong>Using the insured buy-sell agreement guarantees that the estate receives the full value of the sole proprietorship, in cash, immediately after the death of the sole proprietor.</span></li>
<li><span><strong>The estate can be settled promptly. </strong>With an insured buy-sell agreement, the sole proprietorship is quickly disposed of for its full value. Then the personal representative can administer the balance of the estate promptly, efficiently, and economically. Further, by establishing the value of the business, the estate can be settled promptly. Cases are common where estate settlements stretch for 5 to 8 years because of an IRS challenge that is less than $100.</span></li>
<li><span><strong>The surviving heirs are relieved of business worries. </strong>The surviving spouse and children are protected under an insured buy-sell agreement. They need not depend on the personal representative to get the highest value for business-related assets, nor must they depend on the new owner to provide future income to the family.</span></li>
</ul>
<span>Provisions in the Buy-Sell Agreement</span>
<p><span>Each sole proprietorship differs from every other; therefore, each buy-sell agreement must be adapted to fit a particular situation. However, certain elements and provisions must be present in all insured buy-sell agreements, which are</span></p>
<p> </p>
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<ul>
<li><span><strong>the parties to the agreement</strong>—The necessary parties are the sole proprietor and the purchaser. Sometimes a trustee who is an impartial third party acts as custodian and beneficiary of the life insurance policies during the lifetime of the sole proprietor. The trustee’s responsibility is to supervise the purchase of the business upon the sole proprietor’s death. In community property states, the spouse of the sole proprietor should be a party to this agreement.</span></li>
<li><span><strong>the purpose of the agreement</strong>—The insured buy-sell agreement should contain a statement of purpose. It should identify the sole proprietorship, identify the status of the purchaser (employee or otherwise), and state that the intent of the parties is to sell and to purchase the business upon the death of the sole proprietor, carrying the life insurance for that purpose.</span></li>
<li><span><strong>description of the assets and liabilities of the sole proprietorship</strong>—These descriptions should be accurate and sholuld carefully define the exact assets and liabilities that comprise the agreement.</span></li>
<li><span><strong>the “first-offer” commitment</strong>—The agreement should contain a provision stating that if the sole proprietor wants to dispose of the business during his or her lifetime, that he or she must first offer it to the purchaser at the contract price.</span></li>
<li><span><strong>the commitment to sell and buy</strong>—The agreement must clearly acknowledge that the estate of the deceased sole proprietor is required to sell the business at the price stipulated in the agreement, and that the purchaser is required to buy the business at that price.</span></li>
<li><span><strong>the purchase price and the valuation formula</strong>—Designating the purchase price to be paid for the business can be done in several ways. The parties must decide whether the purchase price of the business includes all or certain assets, good will, or the responsibility for debts. Sometimes the purchase price is fixed in advance, although the parties may agree to revise this figure periodically. Such revisions of price can be scheduled annually or at other specified times, such as every two or three years. The advantages of this provision are</span>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span>the amount of the purchase price must be clear and unambiguous;</span></li>
<li><span>the sole proprietor, knowing exactly how much his or her estate will receive, can plan for the welfare of his or her family; and</span></li>
<li><span>the purchaser, knowing exactly what amount is necessary for the purchase, can keep the purchase price fully insured.</span></li>
</ul>
</li>
</ul>
<p><span>Because of the changes in asset values or changes in the net worth of the business, several revisions may be necessary. A clause is typically provided stating that the price is valid for one year from the last time of valuation. If a longer period passes, then the purchase price is fixed by an alternative method.</span></p>
<p><span>In addition, a valuation formula should be specified in the agreement. A simple formula fixes the purchase price at the book value shown at the time of purchase. If the death of the sole proprietor is the triggering event for the sale, this provision should state that the book value to be used is the value as-of the date on which the sole proprietor dies, or the value as-of the date on which the last financial statement of the business was issued before the sole proprietor died. If the date of death is used, the provision should specify who is to make the audit and appraisal. Often, this provision specifies on what basis to value the various classes of property among the assets; for example, raw materials, finished goods, etc.</span></p>
<p><span>A formula can also be applied for valuing “good will.” Sometimes the agreement stipulates that good will should be determined by CPAs who are experienced in that type of business enterprise. A frequently used formula averages the net earnings over a period of years. Two items are subtracted from this figure:</span></p>
<ul>
<li>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span>the sum that represents reasonable compensation for the personal services of the sole proprietor; and</span></li>
<li><span>the reasonable percentage of the book value representing interest on the proprietor’s capital.</span></li>
</ol>
</li>
</ul>
<p><span>The resulting amount is multiplied by a stated figure, such as 3, 5, or 7, depending on the nature and stability of the business.</span></p>
<p><span>Another way of valuing a business in a buy-sell agreement is that at the sole proprietor’s death, a panel of three appraisers determines the value. One appraiser is to be appointed by the personal representative of the deceased sole proprietor, one by the purchaser, and the third by the two appraisers already appointed.</span></p>
<p><span>The formula of valuing a business should be the one best suited for the business, and it should be fully understood and agreed to by all parties.</span></p>
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<ul>
<li><span><strong>the financing of the buy-sell agreement with life insurance</strong>—The agreement should contain a clause relating to the purchase and use of the life insurance policy. Often the policy is applied for after executing the buy-sell agreement or during the final draft of the agreement. Therefore, the policy is often referred to as an “attached exhibit.” In addition, the clause should state that the purpose of the policy is to provide capital for the purchase of the business, whether such capital results from the death proceeds or from the cash value. The purchaser is to be credited when the payment is made to the estate.</span></li>
<li><span><strong>provisions for adding, substituting, or withdrawing policies</strong>—As an ongoing business, the value of the sole proprietorship can change after the buy-sell agreement has been executed. Consequently, the amount of life insurance should also be changed. The agreement should provide for the addition, substitution, or withdrawal of policies by the action of all parties.</span></li>
<li><span><strong>provisions relating to business debts</strong>—Upon the death of the sole proprietor, the personal representative is held accountable for the assets of the estate. He or she must collect and conserve the assets and apply them to payment of all debts, both business and personal. The personal representative must then see that all remaining property of the estate is distributed to those who are entitled to it.</span></li>
</ul>
<p><span>If the business assets are sold on a “gross” basis to the purchaser (gross being the total value of all assets with no adjustment for debt or other encumbrances), then a provision referring to the payment of all business debts in the agreement is unnecessary. Such debts are paid by the personal representative along with all other debts of the deceased. However, if the business assets are sold on a “net” basis to the purchaser, then the buy-sell agreement must contain a provision requiring the purchaser to assume and to pay all business debts. (The net value makes the adjustment to debt and other encumbrances.) .</span></p>
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<li><span>In either case, both the purchaser and the estate must have protection that such debts will be satisfied by the obligating party and that a release of these debts has been verified.</span></li>
<li><span><strong>provisions for uninterrupted continuance</strong>—The buy-sell agreement should provide that, upon the death of the sole proprietor, the purchaser immediately takes possession of the sole proprietorship business and continues its operations while the purchase is in process.</span></li>
</ul>
<p><span>To effect this provision, a broad power of attorney can to be used. This power of attorney gives the purchaser the power to conduct the business during the sole proprietor’s lifetime as well, if the sole proprietor’s consents. Further, the sole proprietor’s personal representative can revoke such power when the agreement is finalized or if and when the agreement fails to be completed.</span></p>
<p><span>This section of the buy-sell agreement should also state that the sole proprietor’s personal representative is “held harmless” while the purchaser is operating under the power of attorney provision. Holding the personal representative liable for the actions of the purchaser is unfair, as well as any negative impact on the business that may occur.</span></p>
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<li><span><strong>provisions for amending, revoking, or terminating the agreement</strong>—Events that amend, evoke, or terminate the agreement include the bankruptcy of either party, the termination of employment if the purchaser is an employee, the death of the purchaser before completing and executing the buy-sell agreement, or the sale or liquidation of the business by the sole proprietor.</span></li>
<li><span><strong>provision to bind the heirs</strong>—The buy-sell agreement must specifically bind the estate and the heirs of the deceased sole proprietor to fulfill the terms of the agreement.</span></li>
</ul>
<span>Adjustment to the Buy-Sell Agreement</span>
<p><span>In some circumstances, the amount of insurance proceeds can differ from the purchase price because of the business valuation at the time of purchase. However, the buy-sell agreement should contain provisions if this occurs. For example, if the value of the business changes when the purchaser buys the business (during the lifetime of the sole proprietor), then the valuation sets the price stipulated in the buy-sell agreement. Typically, if the business value upon the death of the sole proprietor is less than the insurance proceeds, the purchase price is the amount of the insurance proceeds. However, a provision can offer certain adjustments to the purchase price if the value of the business is much less than the insurance proceeds. A percentage range is usually stated.</span></p>
<p><span>Conversely, if the value of the business exceeds the insurance proceeds, the balance can be paid in a variety of ways. If the balance is small, the purchaser should be able to pay it in cash when the assets are transferred. But if the balance is large, payments can be established through interest-bearing notes that are secured by the assets of the business, or through personal assets of the purchaser.</span></p>
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<span>2.</span><span>14 - </span><span>Paying Insurance Premiums</span>
<p><span>The purchaser is typically obligated to pay the premiums for the insurance that is carried on the life of the sole proprietor. This is because the purchaser receives the proceeds from the policy to pay for the business. These premium payments are often viewed as advance installment payments for the future purchase of the business. If the purchaser is an employee or group of employees, the premiums can be paid through payroll deductions, ensuring the sole proprietor that the policy is kept current.</span></p>
<p><span>In certain situations where the employee-purchaser does not earn sufficient income to pay the required premiums, the employee’s income can be increased enough so that he or she can afford to pay the premium obligations. This arrangement is desirable because an employee-purchaser is the logical party to the buy-sell agreement. Moreover, the sole proprietor and his or her heirs greatly benefit from this buy-sell arrangement, primarily because of the increased value that the employee-purchaser brings to the business.</span></p>
<p><span>The sole proprietor can also assume part of the premium payments through a split-dollar plan. A split-dollar plan requires the parties to agree on how to split or share the dividends of the policy, which are the premiums, cash values, and death benefits. Variations to a split-dollar plan are many, and the method selected should be one that best fits the situation. A split-dollar arrangement does require additional documentation—that of the split-dollar agreement. The purchaser or a trust must own the policy. In addition, care should be taken so that the maximum tax and estate advantages are secured.</span></p>
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<span>2.</span><span>15 - </span><span>Control Over the Insurance Policies</span>
<p><span>The buy-sell agreement should specify who has ownership rights to the insurance policies during the lifetime of the sole proprietor. The purchaser should own the policy; however, certain situations require that a sole proprietor involve a trustee. If the trust is to be the owner of the policy, provisions protecting the rights and equity (cash value ownership) of the purchaser should be in place. If the sole proprietor shares the insurance policy under a split-dollar arrangement, he or she may be a collateral assignee to the policy.</span></p>
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<span>2.</span><span>16 - </span><span>Beneficiary Arrangements</span>
<p><span>The buy-sell agreement should contain a provision for naming the beneficiary of the insurance policies. If the agreement has a third-party trustee, then the trustee is named as the beneficiary. The agreement is drawn up as a trust indenture (a binding contract of representation), and the provisions follow the general buy-sell agreement modified by the trust provisions. These provisions specify that the trustee is the beneficiary custodian of the policies. If ownership rights in the policy are given to the trustee, then the agreement outlines the conditions under which the trustee can exercise these rights.</span></p>
<p><span>When the sole proprietor dies, the trustee collects the insurance proceeds and supervises the purchase and sale of the sole proprietorship. If the sole proprietor owns the policy, then the value of the death benefit proceeds can be subject to estate taxation, even though the insurance company did not pay the proceeds directly to the estate. If a trust is not involved with the policies, then the purchaser is the logical beneficiary, as he or she is the one who created the fund. The purchaser generally retains ownership of the policy.</span></p>
<p><span>The insurance proceeds are paid to the purchaser, and he or she holds title to the proceeds. The sole proprietor’s representative, who is obligated to sell and transfer the deceased sole proprietor’s business to the purchaser, holds title to the assets of that business. Each party holds title to something of value and is obligated to exchange something of value with something of equal value from the other party.</span></p>
<p><span>If the buy-sell agreement does not have a trustee, then the sole proprietor’s estate can be designated as the beneficiary of the policy. However, this arrangement is not conducive, because it creates an imbalance between the estate and the purchaser—the estate now holds title to both the insurance proceeds and the business assets. Other problems created by this arrangement are</span></p>
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<li><span>the insurance proceeds and the assets of the business are exposed to the claims of creditors;</span></li>
<li><span>the insurance proceeds are now subject to estate taxation. Placing the insurance in a taxable status by making it payable to the estate increases the likelihood of a controversy;</span></li>
<li><span>the insurance proceeds with the assets of the business increase the value of the estate two-fold, because the asset value of the business is duplicated;</span></li>
<li><span>transfer of title of the business assets may have to occur through another document, such as a will. This creates doubt as to whether the insurance proceeds are included in the purchaser’s cost basis for the assets acquired from the deceased.</span></li>
</ul>
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<span>2.</span><span>17 - </span><span>Disposing of Insurance if the Agreement is Terminated</span>
<p><span>If the parties terminate the buy-sell agreement, the cash value of the policy belongs to the owner of the policy. If the purchaser is the owner of the policy, he or she can use those cash values to recover the cost of premiums by surrendering the policy. If a trust has ownership rights in the policy, provisions should allow the party who paid the premiums to use the cash values to recover premium payments.</span></p>
<p><span>The possibility always exists that the purchaser dies before the sole proprietor. In this event, the agreement automatically terminates. If the purchaser is more than one individual, such as a group of employees or an entity, provisions allow for the agreement to continue. However, if the purchaser is one individual, then the buy-sell agreement should provide that the sole proprietor can elect to purchase the insurance on his or her life from the estate of the deceased purchaser at the policy’s cash value.</span></p>
<p><span>Simultaneous with setting up the buy-sell agreement, the sole proprietor can take out an insurance policy on the life of the purchaser. The amount of the policy should be at least equal to the amount of the probable shrinkage that would occur in the value of the business upon eventual liquidation, should the purchaser die first. Using this plan, the sole proprietor purchases, owns, and pays for the insurance policy and is its beneficiary. In the event the sole proprietor dies first, the estate can use the purchaser’s life insurance as collateral for any balance due on the purchase of business assets the purchaser makes, should the value of the business exceed the insurance proceeds of the buy-sell agreement. In the event of the purchasers’ death after the buy-sell agreement has been drawn, the heirs receive the insurance proceeds as payment for any unpaid balance owed under the arrangement. Once the business has been paid for in full, the purchaser can then buy the insurance policy on his or her life for its cash value from the heirs of the deceased sole proprietor.</span></p>
<p><span>This arrangement also benefits purchasers in that when they obtain ownership of the policy on their life from the heirs of the deceased sole proprietor, they can use the policy in a new buy-sell agreement with another party, therefore protecting their heirs in the same manner. This protects purchasers if any health changes occur that could affect the rating or issuance of a policy.</span></p>
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<span>2.</span><span>18 - </span><span>Tax Issues</span>
<p><span>With an insured buy-sell agreement, life insurance premiums are not a deductible expense to the premium payer. If the sole proprietor pays insurance premiums on behalf of an employee purchaser, then the sole proprietor can deduct the amount as wages to the employee. This amount becomes taxable income to the employee purchaser but is not deductible as premiums.</span></p>
<p><span>The Internal Revenue Code provides that life insurance proceeds are not taxable income. For estate tax purposes, the basis of a deceased’s property is its fair market value at death or on the valuation date. Therefore, the sale of capital assets of a sole proprietorship at death results in little or no taxable gain or loss.</span></p>
<p><span>However, uncollected accounts receivable of the sole proprietorship are treated as income, and they do not receive a “stepped up” basis at his or her death. (A “stepped up” basis means the asset owned by the deceased receives a new “cost” basis, which is the actual value of that asset as of the date of death.) If these accounts receivable are sold by the estate, any gain over uncovered costs is considered ordinary income to the estate. Often, the accounts receivable are purchased at a discount, allowing for the possibility of shrinkage in the collection process.</span></p>
<p><span>The federal estate law specifically states the circumstances under which life insurance proceeds are considered taxable or nontaxable to the estate of the insured. Therefore, if the insurance proceeds are nontaxable, the sole proprietorship business is generally taxed at the value stated in the buy-sell agreement. This is true if the purchaser paid for or owned the insurance and the purchaser or trustee acting for the purchaser is the beneficiary.</span></p>
<p><span>On the other hand, if the insurance is arranged in a taxable way, then the insurance proceeds must be included in the taxable estate. Ownership of the insurance, or any rights of ownership, is the deciding factor in bringing the insurance proceeds into the estate. Therefore, if the sole proprietor has any rights of ownership, the insurance proceeds are brought into the estate.</span></p>
<p><span>Should the parties terminate the buy-sell agreement, the cash value of the policy belongs to the owner of the policy. If the purchaser is the owner of the policy, he or she can use those cash values to recover the cost basis of premiums paid by surrendering the policy. If the cash values exceed the purchaser’s cost basis, he or she must pay taxes on the gain upon surrendering the policy.</span></p>
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<span>3.</span><span>1 - </span><span>The Partnership</span>
<p><span>If a person is contractually part of a partnership, then he or she must thoroughly understand all of the details and legal considerations impacting partnerships. Further, he or she must understand the problems that can arise when developing a satisfactory plan for the continuation of a partnership business.</span></p>
<p><span>This chapter begins by identifying when and how a partnership is formed and explores the types of partnerships that can be established, the duties of partners, tax issues of partnerships, events occurring when a partner dies, and many other characteristics of partnerships. By understanding the concepts in this chapter, you will have a thorough knowledge of not only what constitutes a partnership but also what the legal issues are. First, let’s begin with a simple definition.</span></p>
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<span>3.</span><span>2 - </span><span>Defining a Partnership</span>
<p><span>The Uniform Partners Act (UPA) defines a partnership as “an association of two or more persons to carry on as co-owners of a business for profit.” However, understanding partnerships and the relationship of the partners goes far beyond this simple concept.</span></p>
<p><span>Some attributes of a partnership are the following:</span></p>
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<li><span>Two or more owners.</span></li>
<li><span>The existence of a partnership is largely based on the principles of contract law.</span></li>
<li><span>A partnership is a voluntary and concentual arrangement between partners and is based on a written or verbal agreement. Anyone who has legal capacity can enter into a partnership, and the purpose of the partnership must be legal; that is, partnerships obviously cannot conduct illegal activity.</span></li>
<li><span>The principal evidence that a person is a partner in a partnership business is the receipt of a share of the profit or loss of the business.</span></li>
<li><span>Wages, annuities, interest on a loan, etc., do not constitute evidence of partnership for the individual.</span></li>
<li><span>Partnerships can be reconstituted, unlike corporations. A partnership that is reconstituted is reformed rather than dissolved at the end of the fixed term.</span></li>
</ul>
<p><span>In addition to understanding what qualifies as a partnership, recognizing a non-legitimate partnership is also important. Lawful partnerships, like any other business form, can be legitimately used to limit or to reduce tax obligations in some circumstances. However, partnerships are particularly vulnerable to being ruled invalid by the Internal Revenue Service if they are unreal or simulated relationships designed primarily to lower tax liability.</span></p>
<p><span>Those enterprises that are <strong>not </strong>arranged to make a profit do not qualify as partnerships. These organizations are termed nonprofit corporations if the business is incorporated. If the business is not incorporated, it is termed an <strong>unincorporated association</strong>. and is not a partnership. Examples of such organizations are religious, charitable, educational, scientific, civic, social, athletic and patriotic groups or clubs, and trade unions and associations.</span></p>
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<span>3.</span><span>3 - </span><span>Purpose of the Partnership</span>
<p><span>A partnership business must have an identity that it presents to the public and to the Internal Revenue Service. Some professional partnerships, such as CPA or law firms, use the last names of the partners as their partnership name. A partnership can also have two separate names. For example, the partners can use their own last names for the agreement and use a separate name to reinforce the presentation of the business. All partnerships must comply with applicable state laws with respect to the use of names.</span></p>
<p><span>In addition, the partnership agreement normally contains a short statement of the purpose of the business. Examples of such a statement are “the purpose of the Langley Partnership is to engage in the manufacture and sale of cigar boxes;” or “the purpose of the Geraci Brothers Partnership is to purchase, refurbish, and sell used furniture.” Within some limitations, a broadly stated purpose permits expanding the scope of the partnership.</span></p>
<p><span>When entering into a partnership agreement, partners should discuss their personal goals, as well as each partner’s objectives for the business. Each partner should know the other’s fears, weaknesses, and aspirations. A well-planned partnership addresses these issues in advance, hopefully eliminating future problems.</span></p>
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<span>3.</span><span>4 - </span><span>Understanding the Partnership Concept</span>
<p><span>In a partnership, the partners must make a commitment that the success of the partnership depends upon a relationship of trust and confidence. Naturally, the partners’ ability to agree on the most appropriate course of action for the business is essential.</span></p>
<p><span>Formally referring to one’s business relationship or to a business enterprise with the words “partners” or “partnership” are not legal prerequisites to forming a partnership. Simply joining with other persons and running a shared business can create a partnership. However, when these words are used, this ensures that a partnership is intended. For example, if some question exists about whether a person is an employee of a sole proprietorship or whether the person is a partner, calling him or her a partner makes this person a partner in intent.</span></p>
<p><span>Another defining characteristic of a partnership is that partners do not receive salaries; rather, they receive a percentage of the profits, often taking an agreed upon amount from the business at regular intervals, which is commonly called a draw. A draw can be taken monthly or biweekly against the yearly partnership shares. In addition to receiving a share in the profits, partners assume the same percentage of the debts and other obligations.</span></p>
<p><span>Further, partners do not necessarily have to share ownership equally. They can agree on any percentage of ownership or distribution of the profits. For example, one partner could own 40 percent of the partnership, and two others could own 30 percent each. However, in the absence of an agreement otherwise, partners do share ownership equally, regardless of the initial contributions to the partnership.</span></p>
<p><span>To avoid great difficulty in the event of a disability or death of one of the partners, a business continuation plan is essential. This is true not only for the surviving partnership, but also for the deceased partner’s family. In the absence of such a plan, the partnership is automatically dissolved. The deceased partner’s estate in entitled to receive its share of the partnership assets, and the surviving partners must finalize the partnership business. In many cases, the partnership assets must be sold to settle with the estate of the deceased partner.</span></p>
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<div style="margin-left:auto;"><span>3.</span><span>5 - </span><span>When is a Partnership Created?</span>
<p><span>The following components indicate that a partnership has been created:</span></p>
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<ul>
<li><span>the receipt, or right to receive, a share of the profits;</span></li>
<li><span>the expression of the intent to be partners;</span></li>
<li><span>the participation, or right to participate, in the control of the business;</span></li>
<li><span>the sharing, or agreeing to share, losses or liabilities; and</span></li>
<li><span>the contributing, or agreeing to contribute, money or property to the business.</span></li>
</ul>
<p><span>Sometimes confusion arises over whether a legal partner exists. These questions are answered by the intentions of the people doing business together. A partnership is a voluntary relationship, either expressed or implied, so a partner cannot be recruited against his or her will. However, the intention to be a partner <em>can </em>be implied from the circumstances. For example, if two brothers and a sister, who have no other business relationship, each inherit one-third of their father’s business, they do not automatically become partners because they never agreed to do business together. On the other hand, if the three move forward to operate the business, then they have become partners. This is so, even if no written partnership agreement exists between them.</span></p>
<p><span>Note that joining interests does not automatically create a partnership for tax purposes or otherwise. For instance, mere co-owners of a small apartment building are not necessarily partners. Even if they lease the units and share the rents, this activity does not create a partnership if they do not actively conduct a business on or with the property.</span></p>
<p><span>Further, the sharing of the expenses of a project does not automatically create a partnership or even a joint venture. If adjoining landowners dig a common ditch in order to facilitate drainage from both properties, this does not create a partnership for legal or tax purposes.</span></p>
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<div style="margin:0px auto;"><span>3.</span><span>6 - </span><span>How is a Partnership Formed?</span>
<p><span style="font-size:12pt;">A partnership is created by means of an oral or written contract between those desiring to be partners. This instrument is known as <b>Articles of Partnership</b>. A partnership should operate under written articles, although many do not.</span></p>
<p><span style="font-size:12pt;">The Articles of Partnership establish the agreement of the partners. Areas covered in this agreement typically include</span></p>
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<ul type="disc">
<li><span style="font-size:12pt;">the names of the partners;</span></li>
<li><span style="font-size:12pt;">the partnership name;</span></li>
<li><span style="font-size:12pt;">the business to be conducted;</span></li>
<li><span style="font-size:12pt;">the place of business;</span></li>
<li><span style="font-size:12pt;">the contributions of each partner;</span></li>
<li><span style="font-size:12pt;">each partner’s share of the profits and losses;</span></li>
<li><span style="font-size:12pt;">each partner’s special duties;</span></li>
<li><span style="font-size:12pt;">drawing account arrangements;</span></li>
<li><span style="font-size:12pt;">bookkeeping provisions;</span></li>
<li><span style="font-size:12pt;">restrictions of authority on the partners;</span></li>
<li><span style="font-size:12pt;">provisions of settling differences;</span></li>
<li><span style="font-size:12pt;">the duration of the partnership; and</span></li>
<li><span style="font-size:12pt;">provisions for dissolving the partnership.</span></li>
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</ul>
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<div style="margin:0px;color:rgb(0,0,0);font-family:Arial, 'MS Sans Serif', sans-serif, Helvetica;font-size:medium;"><span>3.</span><span>7 - </span><span>Types of Partnerships</span>
<p><span>Naturally, partnerships can be organized for many different purposes. They can sell products or provide services, manufacture, distribute, or even operate as agents. However, professional partnerships such as those of accountants, doctors, or lawyers are subject to special partnership rules, which are set by members of their professions.</span></p>
<p><span>In addition, partnerships can take several forms. Each form of partnership affords the members various powers and subjects them to various liabilities.</span></p>
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<ul>
<li><span><strong>general partnership</strong>—The general partnership is a major form of partnership principally governed by the UPA (see the next section titled “The Uniform Partnership Act (UPA)), and is one of the more simple forms of partnership. In a general partnership, all of the partners are actively involved in conducting the partnership business. Two or more partners act as co-owners of the business, regardless of whether this association is officially call a “partnership.” The partners generally determine the term (length of time) of a general partnership. If the partnership does not prepare its own partnership agreement, the rules of the UPA are applied.</span></li>
<li><span><strong>joint venture</strong>—A joint venture is an express or implied contractual arrangement in the nature of a general partnership. A joint venture is undertaken for a specific transaction and for a specific limited purpose, which is intended to be accomplished within a specific time-frame. In this respect, a joint venture is considered a “limited purpose partnership.” Examples of joint ventures are erecting a single structure, renovating one old building, or offering one series of beginning yoga lessons. Those involved in joint ventures should have a partnership agreement covering the basics of the partnership, as well as the extent of the venture, management issues, staffing issues, conflicts of interest, and tax issues.</span></li>
<li><span><strong>limited partnership</strong>—A limited partnership is a statutorily authorized entity that must be attached to an ongoing business. It is an association between two or more persons, and it has one or more general partners and one or more limited partners. In a limited partnership, the limited partner is sometimes called a “passive partner” who is not actively involved in the conduct of the partnership business.</span></li>
</ul>
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<ul>
<li><span>Like the sole proprietor, the general partner in a limited partnership has personal and unlimited liability for the debts and the obligations of the business. However, the limited partner only contributes capital, and he or she has no right to participate in the management and the operation of the business. Likewise, the limited partner assumes no liability beyond his or her capital contribution. The existence of a limited partnership is not terminated by the death of a limited partner.</span></li>
</ul>
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<li><span><strong>registered limited liability partnership</strong>—A registered limited liability partnership (LLP) is a separate form of a general or a limited partnership. An LLP can be formed by filing an application with the office in the state in which it is registered. A partner in an LLP is not individually liable for debts and obligations of the partnership arising from errors, omissions, negligence, incompetence, or malfeasance committed in the course of the partnership business by another partner, unless at the time, the first partner was directly involved in that activity or knew of it. In most states, LLP registrations must be renewed annually.</span></li>
</ul>
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<span>3.</span><span>8 - </span><span>The Uniform Partnership Act (UPA)</span>
<p><span>The principles of partnership are set forth in the Uniform Partnership Act (UPA), which is a body of law that establishes basic legal rules for partnerships. In most states, the UPA standardizes the partnership law, but most states’ UPA rules can be varied to suit local conditions. Those states that have not adopted the UPA have similar statutes. However, some rules cannot be varied. For example, the UPA rule that “each partner is responsible for all debts of the partnership” cannot be altered.</span></p>
<p><span>The UPA partnership rules are not a requirement for forming a partnership, but all partnerships should have a formal written partnership agreement. In the absence of a written agreement, an oral contract is satisfactory. However, most legal professionals strongly recommend that a written partnership agreement be in place.</span></p>
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<span>3.</span><span>9 - </span><span>The Partnership Agreement</span>
<p><span>The purpose of a partnership agreement is to tailor the agreement between the partners to suit their particular needs and objectives. The rules of an agreement can be varied by an express statement in the partnership agreement. Even if the partners know their state’s UPA rules and decide they want to use them, it is not wise to rely solely on the UPA to define key clauses in any partnership agreement. These clauses should be created by the partners, and this decision should be explicitly expressed in the partnership agreement.</span></p>
<p><span>This agreement stipulates the rights, management, and ownership interests of the partners. A partnership agreement can be as simple or as complex as the business situation dictates. Although Articles of Partnership are not specifically required by the UPA, written partnership agreements are suggested. As identified in a previous section of this chapter, Articles of Partnership state the financial, material, and managerial contributions by the partners into the business and the roles of the partners in the business relationship.</span></p>
<p><span>A well-drafted partnership agreement should be written clearly and should be free of any confusing legal jargon. Further, the agreement should clearly express decisions that the partners have made to meet their needs.</span></p>
<p><span>Legally, the partnership begins whenever the partners agree that it does. In some circumstances, partnerships can be based on an oral agreement. It can even be implied from the circumstances. However, the best approach to a partnership agreement is a written one.</span></p>
<p><span>Eventually, one or more of the partners may want or be forced to discontinue his or her interest in the partnership. This can occur upon the death of one of the partners. Ideally, this event should be planned for in advance in the partnership agreement.</span></p>
<p><span>In addition to establishing the rules of governing the partnership during its existence, the partnership agreement should establish the basics of what will happen if the partnership ends. This issue must be addressed at the time the partnership is formed, not after the death or disability of one of the partners.</span></p>
<p><span>Although creating the perfect partnership agreement does not have a prescribed legal formula, a partnership lawyer can assist the partners and suggest possible solutions to any concerns. The lawyer cannot, however, make basic decisions for the partners, such as what happens when the partnership ends—a partnership agreement must address the real needs and concerns of the partners and the partnership.</span></p>
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<span>3.</span><span>10 - </span><span>The Partnership and Property Rights</span>
<p><span>The partnership method of conducting business is accompanied by specific property rights. (“Property rights” here refer to the ownership interest in the partnership as a business, which is not the same as property owned by the partnership.)</span></p>
<p><span>In a partnership, no partner can assign his or her individual share of ownership—only a creditor of the firm can attach individual ownership rights. While a partner cannot assign “ownership” to another party, he or she can assign an “interest” to another party, which allows that party to receive distributions, etc. (but no ownership rights). Hence, partners can assign their interest to subordinate a loan, for example. The ownership portion of a partnership as an asset has restrictions that are unique to the partnership structure and cannot be viewed as any other asset.</span></p>
<p><span>A working knowledge of these partnership rights is essential for partners to clearly understand the partnership concept and the need for creating a business continuation plan.</span></p>
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<span>3.</span><span>11 - </span><span>The Partnership and Liabilities</span>
<p><span>A partnership implies the unlimited personal liability of each partner. This is a fundamental principle of a partnership. Each partner is personally liable for all partnership debts and obligations that cannot be paid by the partnership itself.</span></p>
<p><span>This rule is provided by the UPA, and this rule cannot be changed. So, partners, as well as the partnership itself, are personally and individually liable for all of the legal obligations of the partnership.</span></p>
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<span>3.</span><span>12 - </span><span>Interests in the Partnership</span>
<p><span>In addition to property rights in partnership assets, each partner owns partnership interest. Partnership interest consists of a partner’s share of the profits and surplus. It is considered intangible personal property.</span></p>
<p><span>Under the UPA, a partnership interest is assignable (see next section for definition), but the assignment itself does not dissolve the firm. Further, the assignee does not actually become a partner. The assignee does not have the right to interfere in the management of the business. Likewise, the assignee does not have the right to information about the partnership’s affairs. However, the assignee is entitled to receive the profits that the assignor would have received. Further, if the assignment makes such provisions, the assignee can receive the assignor’s share of the profits and surplus upon the dissolution, accounting, and ”winding up” of the partnership.</span></p>
<p><span>In the event of a partner’s death, the partnership interest goes to an executor or administrator who is entitled to receive its value in cash as the deceased’s share, which is distributed to the heirs.</span></p>
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<span>3.</span><span>13 - </span><span>Express, Implied, and Apparent Authority</span>
<p><span>Two types of authority are conveyed to partners: (1) express authority actually bestowed upon a partner, and (2) implied actual authority. Express authority can be stated in the partnership agreement, or it can simply originate from the decisions made by a majority of the partners.</span></p>
<p><span>Implied actual authority includes authority that is neither expressly granted nor expressly denied; rather, it is reasonably deduced from the nature of the partnership.</span></p>
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<span>3.</span><span>14 - </span><span>The Duties of the Partners</span>
<p><span>Partners are considered fiduciaries to each other. The fiduciary relationship between partners means that each partner owes complete loyalty to the partnership. He or she may not engage in any activity that conflicts with the interest of the partnership. Further, each partner owes the duty of good faith and utmost loyalty to the other partners. This rule of uncompromising fidelity is supreme. The fiduciary relationship exists based upon the high standard of trust and reliance that the partners must expect from one another. Honesty and integrity are the most important requirements of a partnership.</span></p>
<p><span>The fiduciary ties between the partners are the ties that bind the partnership. This, of course, is essential to the long-term success of a partnership. If the partnership is unsuccessful, the surviving partners will have little or nothing for their families in the event a partner dies.</span></p>
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<span>3.</span><span>15 - </span><span>Prohibited Actions of a Partner</span>
<p><span>Just as a partner is obligated to perform certain duties for the partnership, partners also are legally prohibited from doing certain things. For example,</span></p>
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<ul>
<li><span>a partner cannot refuse to disclose material facts affecting the partnership business to the other partners;</span></li>
<li><span>a partner cannot secretly obtain for himself or herself an opportunity that is available to the partnership;</span></li>
<li><span>partners cannot fail to distribute partnership profits to other members of the partnership; and</span></li>
<li><span>partnership assets cannot be diverted for one partner’s personal use.</span></li>
</ul>
<p><span>According to recent rulings of the courts, even those who have seriously discussed a partnership must adhere to the same standards of good faith that bind partners. This is true even if those involved do not actually participate in a partnership agreement.</span></p>
<p><span>For example, suppose two people seriously plan to open a shoe repair business, and they locate the perfect storefront. For one person to lease the store first as a sole proprietor and engage in the business alone, cutting the other out of the arrangement, is a breach of fiduciary duty.</span></p>
<p><span>Precisely when the partner-like responsibility begins is not completely clear. However, some fiduciary duties of trust exist when negotiations are involved.</span></p>
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<span>3.</span><span>16 - </span><span>The Continuity of the Life of a Partnership</span>
<p><span>Naturally, a plan that ensures the continuation of the partnership business is essential if the partnership business can no longer continue to operate. Certain withdrawal events prompt the need for dissolving, “winding up,” or terminating the partnership.</span></p>
<p><span>Withdrawal events are</span></p>
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<ul>
<li><span>when the partnership receives notice of a partner’s election to withdraw;</span></li>
<li><span>when a partner is ejected from the partnership by partner vote or by judicial decree;</span></li>
<li><span>a partner declares bankruptcy; and</span></li>
<li><span>a partner dies.</span></li>
</ul>
<p><span>When one of these events triggers the decision to end a partnership, any existing partnership business should be completed as quickly as possible. From a legal perspective, ending a partnership business involves three stages: (1) dissolving, (2) “winding up,” and (3) terminating. These stages are discussed in detail in the section “What Happens to a Partnership After the Death of a Partner?” later in this chapter.</span></p>
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<span>3.</span><span>17 - </span><span>The Legal Relationship among Partners</span>
<p><span>The most important decision in organizing a partnership is in selecting the partners. The relationship of the partners to each other is a consideration separate from the relationship of the partners to third parties. When entering a partnership, the partners are legally bound to certain obligations and certain rights. As long as the rights of third parties are not affected, the partners can vary their rights and obligations by agreement.</span></p>
<p><span>Although many partnership agreements specifically detail the responsibilities, duties, and restrictions on partners, this type of detail is usually not helpful, because trust is the central ingredient in any partnership. Mistrust between partners does not provide a sound basis for the partnership.</span></p>
<p><span>Furthermore, no agreements, clauses, or provisions can make up for the absence of faith and trust. If mistrust is apparent, perhaps the partners should seriously questions whether the partnership is a good idea.</span></p>
<p><span>A partner has the authority to bind the partnership (hold it accountable) by making decisions in the ordinary course of partnership business. The rights and duties of the partners between themselves are basically controlled by the terms of the partnership agreement. However, this is not true for those outside the partnership agreement. So, all the partners must explicitly trust each other.</span></p>
<p><span>A partner cannot, however, bind all the other partners, regardless of what he or she does. Many actions are prohibited by the UPA. For example, the UPA prohibits</span></p>
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<li><span>conveying a partner’s interest in any partnership property;</span></li>
<li><span>mortgaging a partnership property to a lien to cover personal debts;</span></li>
<li><span>attempting to dispose of partnership property, rather than a partner’s own interest in the partnership, through a will;</span></li>
<li><span>assigning a partnership property in trust for creditors or on the assignee’s promise to pay the debts of the partnership;</span></li>
<li><span>disposing of the “good will” of the partnership business;</span></li>
<li><span>committing any act that would make it impossible to conduct the ordinary business of the partnership; and</span></li>
<li><span>agreeing to a judgment for the other side in a lawsuit against the partnership.</span></li>
</ul>
<p><span>Even though the UPA prohibits these acts, the partnership agreement can supersede these acts with express provisions. However, regardless of what the partnership agreement states, partners in trading partnerships (those directly involved in trade, such as merchants selling a product) do have the apparent authority to borrow money or to execute loans on behalf of the partnership.</span></p>
<p><span>Non-trading partnerships include service businesses, such as dry cleaners, accounting firms, restaurants, banks, real estate enterprises, law firms, and others. Partners in non-trading partnerships do not have the apparent authority to borrow money on behalf of the partnership. In trading partnerships, if one partner is unreliable, this exposes the other partner to his or her irresponsible acts. For example, even without actual authorization, an untrustworthy partner can borrow money, leaving the other partners responsible for the loan.</span></p>
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<span>3.</span><span>18 - </span><span>Contributions to the Partnership</span>
<p><span>Naturally, a healthy respect for money is critical for a partnership business to work. Conflicts over money can consume a partnership. All prospective partners must reach an understanding of exactly how they will handle money matters. This arrangement should be specified in the partnership agreement.</span></p>
<p><span>The sum total of the money and the property the partners contribute is directed to the exclusive and permanent use in the enterprise; this sum is called partnership capital. No partner can withdraw any part of his or her capital contribution without the consent of the other partners.</span></p>
<p><span>Where profits are concerned, profits are always distinguished from capital. If the partnership agreement defines how profits are to be distributed but does not mention losses, then the UPA provides that each partner must contribute toward the losses to his or her share of profits.</span></p>
<p><span>Alternately, a partnership may decide to divide profits and losses equally based on such issues as a disproportionate monetary contribution or some special skills contributed by one partner—no formula exists for distributing profits or losses. Rather, the partners decide on who to distribute them. Moreover, the partnership can divide the profits and losses in any way that all partners agree is fair. However, these transactions must be considered when contemplating the possibility that one partner may die during the course of the partnership agreement.</span></p>
<span>Contributing Assets, Cash, or Skills/Services</span>
<p><span>The partnership requires assets to commence business, which are initially contributed by the partners. Partnership property is the sum of all of the partnership assets, including initial capital contributions.</span></p>
<p><span>In simple situations, each partner contributes cash only. Sometimes partners contribute equal amounts; sometimes they contribute unequal amounts. Regardless, if all the contributions are cash contributions, the partnership agreement should specifically state how much money each partner has contributed toward the partnership.</span></p>
<p><span>In other cases, partners may contribute no capital, instead contributing only their specific skill or some personal services. For example, two partners may decide that a third partner will receive a partner’s interest in a partnership business because of a promise to contribute needed legal expertise.</span></p>
<span>Property Contributions</span>
<p><span>Another type of contribution partners can make is property. Property contributions can be office furnishings or equipment or even the building that will house the partnership. In some instances, a partner may not want to contribute the building itself, so he or she may contribute the use of the building and lease it to the partnership.</span></p>
<p><span>Any value of property contributed to a partnership must be ascertained as well as the condition of the property contributed. The partners must agree on how to value property that a partner contributes to the partnership.</span></p>
<p><span>So what is considered a property contribution? A partner can sell, loan, lease, or rent property to the partnership, all of which are considered property contributions and are thus distinguished from capital contributions. Property contribution transactions are appropriate when, for example, one partner possesses an item that the partnership wants to use, such as an item that is too expensive for the partnership to buy.</span></p>
<span>Tracking Contributions</span>
<p><span>Tracking contributions of any type can be a complex matter. Tracking usually becomes even more complicated as the partnership progresses and acquires more assets. In the event of the death of a partner, accurate distributions must be made to surviving partners, so the accurate tracking of partners’ contributions is essential.</span></p>
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<span>3.</span><span>19 - </span><span>The Rights of the Partners</span>
<p><span>Although partners can choose for themselves certain activities within the business for which they are individually responsible or in which they can specialize, each partner has an equal voice in the managing the business.</span></p>
<p><span>Upon termination of the partnership, such as in the event of the death of a partner, each partner is entitled to be repaid his or her capital contribution to the partnership. Unless otherwise agreed, partners are not entitled to interest on this sum. However, if the return of their capital contribution is delayed, then they are entitled to interest at the legal rate from the date when their capital contribution should have been paid.</span></p>
<p><span>Additionally, each partner has the right and the full power to represent and to bind the partnership within the normal cause of business. As established earlier in this chapter, trust is the foundation of the partnership. Partners are always at risk that one partner can obligate the other partners, even if they never authorized this partner to do so. In fact, a partner can bind a partnership even when the other partners instruct him or her not to, so trust becomes a very important element in the partnership relationship.</span></p>
<p><span>For example, suppose three people are partners in a retail jewelry store, and they discuss buying an expensive assortment of watches for the upcoming Christmas season. They vote two-to-one against buying such a particularly expensive collection. Even so, the losing partner can purchase the costly collection anyway with a manufacturer who has no knowledge of the other partners’ opposition to the purchase. Because this activity is considered to be within the normal cause of business, this act binds the partnership.</span></p>
<p><span>Although the powers of any partner can be limited by means of the partnership agreement, any limits are unlikely to be binding on people outside the partnership and who have no actual knowledge of the limitations. In fact, outsiders are entitled to rely on the apparent authority of a partner. The outsiders’ relationship with the partner is determined by the customs of the particular trade or the business involved.</span></p>
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<span>3.</span><span>20 - </span><span>Ownership of Partnership Property</span>
<p><span>The title to real estate that is purchased with partnership funds is in the name of the partnership, a partner, or in the name of a third party. However, any other property that a partnership owns is typically held in the partnership’s name. The partners are free to decide whether property used by the partnership for the partnership business is to be considered partnership property or if it is to be owned by an individual partner.</span></p>
<p><span>In some cases, such property is used only by the partnership. The property can be loaned, leased, rented, or even used free. Unless an express agreement is made to the contrary, property that is acquired with partnership funds is considered partnership property. It is important to remember this with respect to a deceased partner’s estate, wherein the choice of arrangement could unfavorably affect the estate.</span></p>
<p><span>Questions that the courts seek to answer when determining partnership property are the following:</span></p>
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<li><span>In what name was the property purchased?</span></li>
<li><span>What was the source of funds used to buy the property?</span></li>
<li><span>Were insurance, taxes, or liens used to pay for by the property?</span></li>
<li><span>Were income or proceeds from the property treated as partnership funds?</span></li>
<li><span>Was the property used in the partnership business?</span></li>
<li><span>Was the property improved with partnership funds?</span></li>
<li><span>Was the property carried on the books of the partnership as an asset?</span></li>
<li><span>Did the partners make any admissions concerning the ownership of the property?</span></li>
</ul>
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<span>3.</span><span>21 - </span><span>Partners’ Liability of Partnership Debts</span>
<p><span>Even though partners are personally and individually liable for all of the legal obligations of the partnership, they are not, however, liable for the personal, non-partnership debts and obligations of the other partners.</span></p>
<p><span>In addition to debts and obligations incurred in the normal operation of the partnership business, each partner is liable for any damages that result from the negligence of another partner in the course of partnership business. Additionally, each partner is liable for damages resulting from fraud or other intentional acts committed by other partners in the ordinary course of partnership business.</span></p>
<p><span>For example, suppose three people are partners in a catering service. Two partners are wealthy, and the other one is not. The partnership has just opened and the partners have not yet procured their insurance. Driving on his way to a catering event, the poor partner hits another car and injures all of the family members in the car. The family’s lawyer sues the partnership and is awarded a considerable judgment against the business.</span></p>
<p><span>Under the circumstances, the wealthier partners are just as personally liable as the poor partner for any amount of the judgment that is unpaid by the business. That is, they are personally liable for what is left unpaid after all partnership assets have been used, so their personal property can be seized to satisfy the judgment. This can include their homes, cars, etc., depending upon what property is protected by their state’s debtors’ exemption laws.</span></p>
<p><span>Further, a <strong>silent partner</strong>, one whose membership in the partnership is not revealed to the public, is as liable for partnership debts as any other partner. However, a <strong>sub-partner </strong>is not, because a sub-partner is not legally involved with the partnership. A sub-partner is a person who makes a separate agreement with one partner to share in that partner’s profits.</span></p>
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<span>3.</span><span>22 - </span><span>Public Liability of the Partnership</span>
<p><span>All traditional legal rules of responsibility apply to partnerships. For example, all partnerships must competently perform any services they provide to the public. Otherwise, the partnership can be liable for negligence on the part of the partnership in general or on the part of its employees. Competence means that a partner must use the level of professional skill, care, and diligence that generally applies to a profession or trade.</span></p>
<p><span>In committing a negligent act, the partnership is liable for “any wrongful act or omission of any partner acting in the ordinary course of business of the partnership where loss or injury is caused to any person.” So, using the example of the catering service partner, if a partner negligently causes an accident while driving a car on partnership business, the entire partnership is liable for any damages. Generally, the partnership is also liable for an intentionally wrongful act, deceit, or assault a partner commits during the course of partnership business.</span></p>
<p><span>Of course, liability insurance can be purchased to insure against such occurrences. Premiums are paid for protection against occurrences that are relatively unlikely. Notwithstanding, one convincing negligent action can ruin a partnership, leaving the partners and their families without support.</span></p>
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<div style="margin:0px auto;"><span>3.</span><span>23 - </span><span>Rights of a Partner Against the Partnership</span>
<p><span style="font-size:12pt;">Even in a well-intentioned and well-planned partnership, serious disagreements sometimes occur. In these circumstances, partners have formal legal rights by way of the provisions of the UPA. These include the following:</span></p>
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<li><span style="font-size:12pt;">Each partner is entitled to all partnership information at any time, and each partner has the duty to supply this information.</span></li>
<li><span style="font-size:12pt;">Each partner has an equal right with the other partners to possess partnership property for partnership purposes, and a partner cannot assign his or her right of partnership property.</span></li>
<li><span style="font-size:12pt;">Each partner is entitled to an accounting of the partnership assets when circumstances warrant it.</span></li>
<li><span style="font-size:12pt;">Each partner has the right to legal action for an injunction to restrain illegal partnership acts and to appoint a receiver to handle the partnership assets.</span></li>
<li><span style="font-size:12pt;">Each partner has the right to “breach of contract” actions concerning the partnership agreement.</span></li>
<li><span style="font-size:12pt;">Each partner has the right to legal action to dissolve the partnership under certain circumstances.</span></li>
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<div style="margin:0px;"><span>3.</span><span>24 - </span><span>Tax Issues</span>
<p><span>In the event of the death of a partner, the partnership distributes cash in payment of his or her share of the partnership. In such a case, the gain is not recognized to the partner’s estate, except to the extent that the distributed money exceeds the value/cost basis of the deceased portion of ownership (interest) in the business (partnership).</span></p>
<span>Distributive Share</span>
<p><span>The partnership itself is not subject to taxation. Rather, the partnership is simply a “pass through” to the individual partners. The partners pay their shares of income tax through their own individual tax returns. Each partner is taxed on his or her <strong>distributive share</strong>of partnership income. The distributive share is the amount of money a partner is considered to have received as income according to the Internal Revenue Service Code. A partner’s distributive share can be more than the profits or payments he or she actually receives from the partnership. This often occurs when profits are retained in the business.</span></p>
<p><span>Partnerships cannot retain significant earnings for such things as future expansion or anticipated expenses without the partners having to pay retained earnings tax on that money.</span></p>
<span>Tax Consequences of Contributions</span>
<p><span>No taxable gain or loss occurs simply because money is transferred from a partner to the partnership. Likewise, no taxable gain or loss occurs if a partner withdraws some or all of the money he or she has already contributed to the partnership. However, if a partner contributes property, especially property like real estate that may have increased or decreased in value since buying it, the tax consequences of these transactions can become quite complex. Such a situation can affect the partnership only after the death of a partner.</span></p>
<p><span>When establishing and tracking partners’ capital accounts for future consideration in the event the death of a partner or the termination of the partnership, the following issues must be considered:</span></p>
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<li><span>How much capital is required to operate the partnership?</span></li>
<li><span>What are the ratios of capital to be contributed by each partner?</span></li>
<li><span>Are additional contributions mandatory or voluntary?</span></li>
<li><span>If the contributions are other than cash, what are the complete descriptions of the property?</span></li>
<li><span>If the contributions are other than cash, what is the valuation of the property?</span></li>
<li><span>What is the status of loans made to the partnership by various partners?</span></li>
<li><span>What has been the withdrawal of cash or property from the partnership?</span></li>
</ul>
<p><span>Other tax issues involving contributed property also need to be considered. For example, the contribution of real estate with an outstanding mortgage or any encumbered property or an automobile with a loan balance can present difficulties. If mortgaged or encumbered property is contributed to a partnership, the partnership liabilities are increased by the amount of the debt.</span></p>
<p><span>The IRSC permits a 1031 tax-free exchange of real estate. For example, a partner or a partnership can sell one piece of real estate and buy another for what the first piece sold. No tax results. Any profits from the sale are rolled over into the second sale.</span></p>
<p><span>However, the seller and buyer of the property must be the same type of legal entity. So, if a partner sells the first property to the partnership, this does not qualify as a tax-free exchange. This issue must be kept in mind when allowing for the distribution of property after the death of a partner.</span></p>
<p><span>Tax consequences are also forthcoming if a person receives an interest in a partnership in return for his or her contribution of services. Services are not regarded as property. Therefore, if a contributing partner receives a capital interest in a partnership in exchange for his or her services, taxable income results.</span></p>
<span>Tax Issues with Family Limited Partnerships</span>
<p><span>A family limited partnership permits business owners and their children to address tax, business succession and estate planning issues simultaneously. Parents can present assets as gifts to their children at highly discounted rates and still maintain control of the assets. Also in a family limited partnership, eventual estate taxes are reduced because of the discounted assets.</span></p>
<p><span>Moreover, the parents are general partners in a family limited partnership, and they hold minor shares of the partnership while maintaining the power and the control. The children are the limited partners, and they own a percentage of the shares. However, the children have no authority, rights, or control over the operation and management of the partnership.</span></p>
<p><span>Compared to many trust vehicles, family limited partnerships have considerable flexibility when parents anticipate leaving a substantial amount of money to their children. Family limited partnerships offer the potential to keep the assets within the family. However, care must be exercised in coordinating the gift of shares of the family limited partnership to the children with regard to the annual gift tax exclusions or the lifetime exclusion.</span></p>
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<span>3.</span><span>25 - </span><span>What Happens to a Partnership After the Death of a Partner?</span>
<p><span>The UPA provides that every partnership dissolves when one of the partners dies. Dissolving the partnership does not automatically result, however, when the partners have consented in their partnership agreement to continue the business.</span></p>
<p><span>For example, if the deceased partner instructs through his or her will that the partnership should be continued after his or her death, the partnership can be continued with the consent of the other partners. However, surviving partners cannot continue the business in the absence of such an agreement. Continuing the business can create liability for the surviving partners if the value of the deceased partners share is diminished.</span></p>
<p><span>On the other hand, if the deceased partner instructs the executor to continue the partnership business, the surviving partners cannot be forced to participate in this arrangement. However, if the surviving partners desire this arrangement, the partnership can be reconstituted with the executor as a new member of the partnership. Technically, this process is that of creating and forming a new partnership.</span></p>
<p><span>The partnership agreement must also address the issue of what happens if a partner becomes mentally ill, disabled, or dies. Otherwise, a serious risk of conflict exists. Any rules on this subject set forth in the partnership agreement are legally enforceable.</span></p>
<p><span>Obviously all of these concerns are significant when surviving partners must effectively handle the remaining affairs of the partnership. The following sections address more fully the series of events that must occur after the death of a partner, which are the dissolution, winding up, termination, and liquidation of the partnership. But first, the<strong>right of first refusal </strong>must first be addressed, which is the right of the remaining partners to have the first opportunity of buying a deceased partner’s share.</span></p>
<span>The Right of First Refusal</span>
<p><span>Most partnership agreements contain provisions prohibiting a partner from transferring his or her interest in the partnership to a third party without giving the remaining partners the opportunity to buy him or her out first. Using the right of first refusal, if one partner dies, the surviving partners have the option to buy the deceased partner’s share and to continue the partnership business.</span></p>
<p><span>If no provisions are made for the right of first refusal, the following situations may arise:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span>Ultimately, the business may have to be liquidated, and it is not likely that used assets sold piecemeal would be worth much.</span></li>
<li><span>If the deceased partner attempted to transfer his or her interest in the partnership without the surviving partners’ consent, this is not only prohibited by the UPA but also could create new or additional conflicts among the surviving partners for the estate.</span></li>
<li><span>The surviving partners may be left with heirs who will try to sell the deceased partner’s interest or who may want to actively participate in the business. The right of first refusal protects the remaining partners.</span></li>
</ul>
<p><span>Within the rules of the UPA, the partnership agreement can be anything the partners want it to be. For example, an heir can inherit a partner’s share of the partnership business and prefer not to be bought out by the remaining partners. The heir may prefer to retain this share.</span></p>
<p><span>With a properly drafted partnership agreement in place, the heir could not force himself or herself into the partnership; the heir would have to sell his or her partnership share. The surviving partners could then decide to make the heir a new partner, or they could decide to buy the heir out.</span></p>
<p><span>With a right of first refusal provision in place, if one partner dies and the surviving partners cannot or will not buy out the interest of the heir, the partnership must be liquidated. The entire business must be sold and the proceeds divided. But, the surviving partners still have a choice. They can either buy the deceased partner’s share of the business or let the partnership be liquidated.</span></p>
<p><span>If a partner suddenly becomes seriously injured, mentally incompetent, or dies, making quick arrangements is nearly impossible. Such circumstances require preplanning. As part of the preplanning effort, a buy-out arrangement should be a part of the partnership agreement. The buy-out arrangement should define the terms by which the surviving partners can buy out the interest of the deceased partner. The following are two key areas that should be covered when formulating a buy-out clause:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span>the method in which to value the partnership must be decided.</span></li>
<li><span>the method in which payments will be made by the surviving partners must be decided.</span></li>
</ol>
<p><span>In the event of the death of a partner, a buy-sell agreement can provide for the continuity of the partnership business.</span></p>
<span>Dissolving a Partnership</span>
<p><span>The UPA defines dissolution as “the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on of the business, as distinguished from the winding up of the business.” Dissolution is discussed first; “winding up” a business is discussed in the next section.</span></p>
<p><span>Dissolving a partnership is the actual decision to end it. It is the point when the partners cease to carry on the business together. Dissolution simply describes a change in the partnership relationship and is a preliminary step to winding up and termination.</span></p>
<p><span>Remember that the partnership is an intimate and voluntary contractual business relationship between the partners. When one partner, for whatever reason, ceases to be a member of the partnership, the partnership, as it is known, no longer exists.</span></p>
<p><span>Further, dissolving a partnership changes the legal relationship of the partners. From the legal perspective, no new partnership business can be undertaken after the partnership is dissolved. To limit their liabilities, sometimes a partnership sends formal written notices to creditors and to other business contacts advising them that the partnership has been dissolved and cannot undertake new business. However, no official or government office or requirement currently requires that this notice be recorded.</span></p>
<p><span>Essentially, dissolving a partnership terminates the authority of the remaining partners to act for the partnership, except to the limited extent necessary to wind up the firm’s business. Dissolution does not refer to the other steps in the process of completing and finishing a partnership. Dissolution is distinguished from winding up and terminating the business. It has nothing to do with whether the partnership business continues with different partners as a new and separate identity or whether the partners are going their separate ways. It is simply the act of <strong>deciding not to continue </strong>the partnership in its current form.</span></p>
<p><span>Of course, the partnership business can be continued after the dissolution process by forming another partnership. This is known as <strong>reconstituting the partnership</strong>. The partnership can be reconstituted under another form, perhaps with only the remaining partners or with the substitution of a new partner for the deceased partner.</span></p>
<p><span>If the deceased partner had no buy-out agreement with the other members of the partnership, his or her share of the partnership must be handled through probate. If the partnership agreement provides for the remaining partners to buy out the deceased partners share, the probate process can be eliminated.</span></p>
<p><span>Forming a new entity does not necessarily have to be another partnership. If a new entity is created and has only one survivor, a sole proprietorship can also be formed. If, upon the death of a partner, the surviving partners decide to incorporate, then the new entity created can be a corporation.</span></p>
<span>The Winding Up of a Partnership</span>
<p><span>People decide to dissolve a partnership for many reasons, but the principal cause is the death of a partner. After dissolving a partnership, the surviving partners have the duty to wind up the partnership affairs without delay. Upon the death of a partner, the surviving partner succeeds to the ownership of the firm’s assets as a <strong>liquidating trustee</strong>. In fact, winding up is sometimes referred to as <strong>liquidation</strong>. (See the next section in this chapter for more information on the liquidation process.)</span></p>
<p><span>The winding up of a partnership is the responsibility of the surviving partners, not that of the personal representative. Partners in a dissolved partnership retain the authority to carry on only to the extent necessary to bring an end to existing partnership business. Under the UPA, each partner is liable for his or her share of any liability created by the partners in the course of closing down partnership business, just as if the partnership had not been dissolved.</span></p>
<p><span>The surviving partners do have some discretion on how to wind up the partnership after the dissolution. They may do the things necessary to close down the existing partnership business. However, if the surviving partners do not act diligently and in good faith in winding up the partnership business, the courts can appoint a <strong>receiver</strong>. Because of the receiver’s fiduciary status, each partner is held responsible to the estate of the deceased partner as a trustee of the partnership assets.</span></p>
<p><span>During the winding up process, the surviving partners must make a fair and complete disclosure of all facts affecting the partnership assets. They must account for all property values, tangible or intangible. Further, the partners may have the burden of proving that this trusteeship is carried out in exact compliance with the high standards of responsibility required of trustees. Given the great amount at stake, the partnership needs a plan that relieves the individual partners of this burdensome status.</span></p>
<p><span>In some states, the surviving partners are required to give a bond as a condition of their rights to manage and to settle the partnership affairs. If the surviving partners do not give the required bond within the time specified, the personal representative of the deceased must give the bond and become the administrator of the partnership.</span></p>
<p><span>Although the UPA specifically provides that no partners are entitled to compensation for acting in the partnership business, they are entitled to reasonable compensation for their services in winding up the partnership affairs. If the surviving partners commit any breach of fiduciary duty, they can be disqualified from receiving compensation for winding up the partnership business.</span></p>
<p><span>As liquidators, one of the first duties of the surviving partners is to collect the partnership’s accounts receivable. Undoubtedly, some of the accounts receivable will not be able to be collected. Perhaps inventory or equipment will have to be disposed of for cash. Selling the inventory is usually accomplished through secondhand dealers, who sell the goods for only a fraction of their original value. This could cause ruinous consequences not only to the partnership, but to the estate of the deceased as well. Further, intangible assets such as “going concern” value and good will typically disappear. Their loss is total.</span></p>
<p><span>So what about the deceased’s steady income? If the partnership was successful, he or she probably made consistent withdrawals, and his or her family’s comforts were geared toward this income. However, the surviving partners cannot make any payments of any type to the deceased partner’s family until the business is closed out. During this time, the family must rely on life insurance proceeds or on advances the personal representative may make from the deceased’s personal estate.</span></p>
<p><span>Under the UPA, the personal representative cannot interfere with the winding up of the partnership unless the surviving partners have acted illegally or unless the process has been unreasonably delayed. Otherwise, the personal representative must wait until the winding up process has been completed. In the meantime, the personal representative cannot fully appraise the estate or complete the estate tax scheduled until the deceased partner has been liquidated and his or her share has been ascertained. During this time, the family may experience a shortage of assets, or the business of the surviving partners could possibly be jeopardized.</span></p>
<span>Terminating a Partnership</span>
<p><span>The final step in the process after a partner dies is the actual termination of the partnership business. Termination effectively ends the surviving partners’ authority—it is the ultimate result of the winding up of the partnership affairs.</span></p>
<p><span>Once the partnership ends, no further partnership business of any kind is legally authorized. If a creditor, however, acting in good faith and without the knowledge of the dissolution of the partnership, extends credit to a surviving partner for matters that are deemed part of the partnership business but which in reality are not because of the dissolution and termination of the partnership, all of the partners can be held liable for this debt.</span></p>
<span>Liquidating a Partnership after the Death of a Partner</span>
<p><span>In the event of the death of a partner, there are many sacrifices and losses suffered by everyone. The surviving partners and the heirs suffer heavy losses if the business is improperly continued. The following is a discussion of alternatives, if no plans are made for the community of a partnership prior to the death of a partner.</span></p>
<p> </p>
<p> </p>
<span>3.</span><span>26 - </span><span>What Happens to the Business After Concluding the Partnership?</span>
<p><span>After a partnership has been concluded after the death of a partner, the surviving partners have many decisions to make and factors to consider. Among these are whether they want to</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span>incorporate the personal representative as a partner;</span></li>
<li><span>form a new partnership with heirs;</span></li>
<li><span>purchase the deceased partner’s interest in the business.</span></li>
</ul>
<p><span>These scenarios are described in the following sections.</span></p>
<span>The Personal Representative as a Partner</span>
<p><span>Some states have enacted special statutes that permit the partnership business to be continued under certain conditions with the deceased partner’s personal representative as a partner.</span></p>
<p><span>This plan, however, cannot function unless the surviving partners agree to it. They may refuse if the personal representative is unfamiliar with the business or if the court has limited his or her liability. Further, such a plan is contingent upon the personal representative’s willingness to be a partner.</span></p>
<span>Forming a New Partnership with Heirs</span>
<p><span>Sometimes, rather than face liquidation, the surviving partners form a new partnership with the heirs. However, this presents legal and economic obstacles.</span></p>
<p><span>The first obstacle encountered with forming a new partnership with heirs is that the heirs usually cannot enter the partnership until the administration proceedings are completed. Such a plan is only possible when the only heir and the personal representative are the same person. Even then, the deceased’s creditors and the tax authorities must be satisfied first.</span></p>
<p><span>Another legal obstacle is the rule that no one can force another to be his or her partner. If the surviving partners want to continue the business with the heir, they can do so only if the heir is willing.</span></p>
<p><span>Surviving partners sometimes continue the business by forming a new partnership with the spouse of the deceased partner. It is nearly impossible to arrange a partnership after death because the burdens are unequally shared: the spouse is often inexperienced and usually has another agenda.</span></p>
<p><span>Moreover, the surviving partners and the heir may have different objectives for the business. The surviving partners probably want to continue to develop and expand the business, often at the expense of immediate profits. The heir, on the other hand, probably wants a current income.</span></p>
<p><span>From an economic perspective, unless the new partner has been active in the management of the partnership business, the surviving partners have the bulk of responsibility for ensuring the business survives.</span></p>
<span>When Heirs Purchase a Partner’s Interest</span>
<p><span>Sometimes the heirs want to purchase the interest of the surviving partners. This plan has many disadvantages. First, the surviving partners have a legal duty to liquidate the business, and all creditors must be satisfied first. Surviving partners can be relieved of liquidating the business only if the personal administrator and all heirs consent. Minor heirs are unable to give consent; other heirs may be unwilling.</span></p>
<p><span>Another issue with heirs purchasing the surviving partner’s interest is that the surviving partners would be selling themselves out of the jobs and would have to start over. The heirs would have the burden of managing the business without the skill and advice of the deceased or of the surviving partners.</span></p>
<p><span>Finally, the heirs may have to compete with the surviving partners. However, such a plan is an alternative solution to liquidating the partnership.</span></p>
<span>Purchasing a Partner’s Interest</span>
<p><span>Sometimes the surviving partners may want to avoid the sacrifices and losses of liquidating the partnership and decide to purchase the deceased partner’s interest. The first obstacle to overcome is to obtain the necessary cash to pay for the deceased’s interest. If the surviving partners do not have sufficient personal wealth, they would have to borrow the money and pay the debt over a period of time.</span></p>
<p><span>When purchasing the deceased partners interest, surviving partners also have legal obstacles to contend with. First, the deceased’s personal representative can demand that the business be liquidated. Second, the surviving partners must have a sound purchase contract that withstands any legal attacks by dissatisfied heirs.</span></p>
<p><span>In many states, if a surviving partner is also the personal representative of the estate, this partner is precluded from making a binding sale to himself or herself, because a fiduciary cannot purchase from himself or herself.</span></p>
<p> </p>
<p> </p>
<span>3.</span><span>27 - </span><span>The Buy-Sell Agreement Alternative to Liquidation</span>
<p><span>All of the previous scenarios have addressed situations where no agreement to purchase had been entered into before the death of a partner. Ideally, a plan is created before the death of a partner and thereby eliminates all possibilities of liquidation losses. The buy-sell agreement is an excellent way to achieve this objective.</span></p>
<p><span>As with the buy-sell agreement discussed for use in the sole proprietorship, although the buy-sell agreement itself seems to accomplish the objective of business continuation, it must also be properly financed. The plan cannot be implemented if the funds to conduct the transaction are unavailable.</span></p>
<span>Financing the Buy-Sell Agreement without Insurance</span>
<p><span>If the partnership is successful and cash rich, the partners may be able to produce the cash necessary to finalize the buy-sell agreement in the event of the death of one of the partners. Without using insurance to finance the buy-sell agreement, the partners could</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span>build up the purchase price in advance through savings. This plan is impractical because no one knows exactly when the funds will be required. It may be days, months, or even years.</span></li>
<li><span>pay the purchase price in installments. This plan is impractical because it essentially mortgages the partnership business and the futures of the surviving partners.</span></li>
<li><span>borrow the purchase prices at the time of death. This plan is impractical because the ability to borrow cannot be assured beforehand, and issues are associated with mortgaging the futures of the partnership business and the surviving partners.</span></li>
</ul>
<span>Benefits of the Insured Buy-Sell Agreement</span>
<p><span>Just because a partnership agreement has a provision that, in the event of the death of a partner, the surviving partner’s interest will be paid in a lump sum or on a set schedule does not necessarily mean that the partnership will actually have sufficient money to make that payment.</span></p>
<p><span>A good way to ensure sufficient funds is for the partnership business to buy life insurance on each partner. For many partnerships, this is a practical way of obtaining the money needed to pay off a deceased partner’s interest. A life insurance policy serves as a legal exchange for a deceased partner’s interest in the partnership. If a partner dies, the partnership-financed insurance policy pays off the deceased’s share. The policy proceeds become partnership property, and partnership-operating income does not have to be used for buying the interest of the deceased.</span></p>
<p><span>In addition, the benefits of an insured buy-sell agreement are many. The surviving partners, the heirs, the estate, and the partners all reap benefits during their lifetimes. The benefits to the surviving partners are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span><strong>the future of the partnership is better assured</strong>—The insured buy-sell agreement ensures the continuation of the partnership business without interruption. The plan expedites the purchase of the deceased partner’s interest. Because the agreement is already set up, the price is already agreed upon, and the money for the purchase is available. Further, the business remains in tact.</span></li>
<li><span><strong>the surviving partners avoid liquidation losses</strong>—The liquidation of a going business invariably results in substantial losses. This is avoided with the insured buy-sell agreement.</span></li>
<li><span><strong>the surviving partners avoid becoming liquidating trustees</strong>—Using a buy-sell agreement, the surviving partners have the status of “purchases” rather than that of liquidating trustees, which is certainly a burdensome position.</span></li>
</ul>
<p><span>The benefits to the heirs and the estate are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span><strong>the estate receives payment in full and in cash immediately</strong>—The insured buy-sell agreement immediately places the full amount of the sale price of the deceased partner’s interest in the firm in the hands of the executor, which avoids any bickering, bargaining, or delay.</span></li>
<li><span><strong>the estate can be settled promptly and efficiently</strong>—Using a buy-sell agreement, the immediate cash allows the executor to promptly, efficiently, and economically administer the estate.</span></li>
<li><span><strong>the surviving spouse is relieved of business worries</strong>—The surviving spouse is free from any future responsibilities of the partnership.</span></li>
</ul>
<p><span>The benefits to the partners during their lifetimes are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span><strong>the partnership is stabilized</strong>—With the stabilization of the business assured, the partners and their customers are free to enter into permanent dealings. Employees are assured of a more secure organization, and the funds of the partnership are not drained.</span></li>
<li><span><strong>a savings medium is provided</strong>—The insured buy-sell agreement is essentially an advance installment method of purchasing a deceased partner’s interest. This is a savings program automatically completed. After a few years, the policy contains a guaranteed cash value, making it a convenient and effective savings program that is directly focused on a single objective.</span></li>
<li><span><strong>the future of the partnership is bright</strong>—With a buy-sell agreement in place, each partner can predict what will happen in the event of the death of one of the partners. The business will be strong and stable.</span></li>
</ul>
<span>Types of Partnership Buy-Sell Agreements</span>
<p><span>Partnership buy-sell agreements have two basic types: (1) the partners can buy policies on each other, which is referred to as a <strong>cross-purchase plan</strong>; or (2) the partnership itself can buy the policies. This type of buy-sell arrangement is referred to as an <strong>entity agreement</strong>.</span></p>
<span>Cross-Purchase Plan</span>
<p><span>For small partnerships, a cross-purchase plan is the most common and is usually most practical. Using this plan, the partners agree to purchase a deceased partner’s interest in the partnership. The partners pay for and own the life insurance policies on the other partners, but the partnership itself is not a party to the agreement.</span></p>
<p><span>In addition, cross-purchase plans reduce the possibility of unfairly increasing the worth of the deceased partner’s share. The insurance on each partner is in an amount that is approximately the same as his or her share of the purchase price if another partner dies before him or her.</span></p>
<p><span>In a larger partnership, however, a cross-purchase plan is usually not manageable. For example, in a five-person partnership, each partner must purchase four life insurance policies, one for each of the other partners. This means the partners would be purchasing a total of 20 policies, the total cost of which would be extremely high.</span></p>
<span>Entity Agreement</span>
<p><span>Under these circumstances, it makes more sense to set up an entity agreement and have the <em>partnership </em>rather than the individual partners pay for a single policy on each partner’s life. In this way, the partnership itself is a party to the agreement, along with the partners.</span></p>
<span>Factors for Determining the Choice of Agreement</span>
<p><span>Some factors for determining which type of buy-sell agreement is suitable for a particular partnership are the</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span><strong>number of partners</strong>—A large partnership can make the cross-purchase plan impractical.</span></li>
<li><span><strong>ages of the partners</strong>—Where the partners’ ages vary greatly, the younger partners, who typically hold smaller interests in the partnership, may be unable or unwilling to maintain insurance on the older partners, who probably own the larger interests.</span></li>
<li><span><strong>ratio of interest among surviving partners</strong>—Using an entity agreement, surviving partners share ownership in the same ratio as they had before the death of a partner. Using a cross-purchase plan, the surviving partners can specify the proportion of the deceased’s interest that each surviving partner buys, regardless of their current proportionate interests.</span></li>
<li><span><strong>tax factors</strong>—Using a cross-purchase agreement, the cash value of the policies that the deceased partner owned on the lives of the other partners is subject to federal estate tax. When the partnership owns the insurance to finance an entity agreement, the value of the insurance on the life of a deceased partner is not included as insurance in his or her gross estate. Other more complicated tax factors must be considered but should be discussed with a competent tax attorney.</span></li>
</ul>
<span>Valuing the Partnership</span>
<p><span>Probably the most important consideration in the buy-sell agreement is the provision for valuing the business—a fair method must be used to determine its worth. Many different methods exist for valuing a business, and no method of valuation is superior to all others. The method of valuation depends on the nature of the business and on the surviving partners’ relationships and their expectations; a method must be employed that fits the situation.</span></p>
<p><span>A primary consideration is that the partnership is given the greatest chance to survive; therefore, the partnership agreement should be drawn to ensure this happens. If the buy-out price is too high, the surviving partners may decide to simply liquidate the business. In addition, how are necessary payments to be made? The heirs may require a lump sum, which could pose a hardship for the partners.</span></p>
<p><span>Naturally, a partnership business is probably not worth more than the value of its hard, tangible assets in the beginning of the business. When the business has become large enough, a more complex and effective valuation method may be necessary.</span></p>
<p><span>Although no method can be precise, some common methods of valuing a partnership after the death of a partner include the</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span>book value method;</span></li>
<li><span>set dollar method;</span></li>
<li><span>appraisal method; and</span></li>
<li><span>capitalization of earnings method;</span></li>
</ul>
<p><span>Each of these methods is described in the following sections.</span></p>
<span>The Book Value Method</span>
<p><span>The book value method for valuing a partnership business is probably the simplest. Simply put, the book value is calculated by taking the total value of the partnership assets and deducting the total partnership liabilities. The result represents the net worth of the business and is the method the UPA requires if the partnership agreement fails to adopt a valuation method.</span></p>
<p><span>Unfortunately, using the book value method to determine the value of a deceased partner’s interest in a partnership does not consider such issues as reputation, a well-known name, good will, etc. Furthermore, the amount of life insurance on a deceased partner is included in the book value of the partnership, where the partnership is the beneficiary of the policy. Because book value often refers to acquisition cost, it probably does not accurately reflect the partnership’s true and current worth, or fair market value.</span></p>
<p><span>The net worth of the partnership is calculated as of the date of the death of a partner. This is the amount the deceased’s estate receives, or is the amount for which the surviving partners acquire the deceased partner’s share. The assets that are normally included in calculating net worth include</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span>all cash, after subtracting all partnership debts owed;</span></li>
<li><span>the current market value of all tangible assets of the partnership. This includes the net value of current inventory plus the present value of other items known as fixed assets, such as office furnishings, manufacturing equipment, the building housing the partnership, etc.</span></li>
<li><span>all accounts receivables that are determined to be reasonably collectable. This is money still owed for work already completed and billed.</span></li>
<li><span>all earned but unbilled fees and all money presently earned for work in progress. These fees are notably important in professional partnerships, such as law or consulting firms. Scenarios included in this category include those where construction work is being done or where an invoice, for whatever reason, has not yet been sent but the revenue has been earned. This is not really the same as an account receivable.</span></li>
</ul>
<p><span>In settling partnership accounts, the UPA ranks the liabilities of the partnership for payment as follows. These liabilities are presented in the order in which they should be paid:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span>those owing to creditors, other than partners;</span></li>
<li><span>those owing to partners, other than for capital and for profits;</span></li>
<li><span>those owing to partners with respect to Capital Planning Strategies;</span></li>
<li><span>those owing to partners with respect to profits.</span></li>
</ol>
<p><span>The book-value method is most effective for new businesses that do not have much except for their fixed assets. These businesses have not yet acquired a good reputation, a well-known name, good will, or an impressive client list. This method is also employed for businesses whose worth is determined by the value of tangible assets, such as a gift store.</span></p>
<span>The Set Dollar Method</span>
<p><span>Using the set dollar method for valuing a partnership is a great tool for preplanning. With the set dollar method, the partners agree in advance that if one partner dies, the others will buy out that partner’s share for a predetermined price. The price is typically re-evaluated every year or so because of business fluctuations and the changing economy.</span></p>
<p><span>The set dollar method is most effective when the primary worth of the business is the activity of the partners. It works best when the business has no substantial hard assets or much value in inventory. This method is particularly good for most partnership service businesses, especially those in their first few years of business.</span></p>
<p><span>In addition, the set dollar method is often used when the partners’ primary concern is the continuation of the business and their relationship with each other. By valuing the partnership in advance, the deceased partner’s estate does not have the burden of getting involved in valuing the partnership interest.</span></p>
<p><span>One of the perks of the set dollar method of valuation is that it combines simplicity with fairness. The buy-out price is fair because it is known and all agreed to it. Also, because the price is predetermined, appraisals and accountants are not necessary when a partner dies.</span></p>
<span>The Appraisal Method</span>
<p><span>Using the appraisal method of partnership valuation, the partners agree to have an independent appraiser determine the worth of the partnership at the time of a partner’s death. The buy-sell agreement could even specify a particular appraiser.</span></p>
<p><span>This method can be a good choice, because at the time the agreement is drafted, the partners cannot possibly know the valuation of the partnership in the future. However, a distinct disadvantage of using the appraisal method is that it often takes some time to get the appraiser’s report. Also, the appraisal method of valuation makes it difficult to determine in advance what a partnership interest is worth if the partners need this information.</span></p>
<p><span>Nonetheless, the appraisal method is highly effective in certain situations. Some businesses are inherently more suitable to this method than others. Such businesses include antique stores, real estate partnerships, and businesses that sell collectibles, such as coins or stamps. This method is also effective for any business where the market can be used to determine the price of inventory.</span></p>
<span>The Capitalization of Earnings Method</span>
<p><span>The capitalization of earnings method is used to demonstrate that the ongoing nature of a successful partnership business has solid value. The capitalization of earnings method values a partnership based on what the business earns annually. Gross earnings or net profits are multiplied by some multiple, which is an arbitrary preset number used to determine the worth of the business. For example, it may be decided that the fair value of a business is three times the average net profits for the past two years. So, three times the average net profits of the partnership for the past two years equals the buy-out price.</span></p>
<p><span>If using a multiplier based on gross earnings rather than on profits, the multiplier should be expressed in terms of a fraction. For example, in a profitable business, one-third of gross earnings might be used.</span></p>
<p><span>Naturally, if the partnership is new, using the capitalization of earnings method to value the partnership is not fair or effective. This method requires several years’ history and profits before it can be practically utilized.</span></p>
<span>Contents of the Insured Buy-Sell Agreement</span>
<p><span>The content of the partnership insured buy-sell agreement is similar to the agreement used when arranging for the sale and purchase of a sole proprietorship. The partnership insured buy-sell agreement should include</span></p>
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<ul>
<li><span>a commitment that the surviving partners or the partnership, in the case of an entity agreement, will buy and the deceased’s partner’s estate will sell the deceased’s interest in the partnership to the surviving partners.</span></li>
<li><span>a commitment for the purchase price of each partner’s interest or the valuation method for determining the purchase price of each partner’s interest in the partnership;</span></li>
<li><span>the commitment to purchase and maintain life insurance on the lives of the partners for financing the purchase;</span></li>
<li><span>a description of the life insurance policies;</span></li>
<li><span>provisions for adding, substituting or withdrawing policies as changes occur in the partnership itself;</span></li>
<li><span>a provision for the ownership and control of the life insurance policy;</span></li>
<li><span>a commitment for the time and method of paying any balance of the purchase price that exceeds the insurance proceeds;</span></li>
<li><span>a commitment to disposing of any insurance proceeds the exceed the purchase price;</span></li>
<li><span>beneficiary arrangements;</span></li>
<li><span>provisions that the deceased’s estate be held harmless from claims of creditors of the business;</span></li>
<li><span>a provision for disposing of the policies if the agreement is terminated during the lifetime of the partners;</span></li>
<li><span>provisions for altering, amending, or terminating the agreement.</span></li>
</ul>
<span>Arrangements for Paying Premiums</span>
<p><span>Surviving partners have several different ways to pay life insurance premiums subject to partnership buy-sell agreements: Some of these ways are listed below:</span></p>
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<ul>
<li><span><strong>premiums paid by partners other than the insured partner</strong>—Using this arrangement, partners other than the insured partner should pay the premiums for each policy, and these payments should be contributed in the same ratio in which the interests of the insured will be purchased and shared between the partners. This arrangement is beneficial when the partnership interests are not equally divided, or if the partners desire unequal interests in the event of the death of a partner.</span></li>
<li><span><strong>the pooling of premiums</strong>—Another method of allocating premiums is to pool the entire premiums required and to require each partner to pay a part. This pooling arrangement results in an equal sharing of the premium payments.</span></li>
<li><span><strong>premiums paid by respective insured’s</strong>—Under this arrangement, each partner pays premiums in the amount of insurance on his or her own life.</span></li>
<li><span><strong>premiums paid by the partnership itself</strong>—Using an entity agreement, the partnership pays the premiums.</span></li>
</ul>
<span>Arrangements for Designating Beneficiaries</span>
<p><span>As with paying premiums, many choices are also available to designate how beneficiaries receive the life insurance proceeds payable in a partnership-insured buy-sell agreement. These choices are as follows:</span></p>
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<li><span><strong>The surviving partners can be designated as beneficiaries</strong>. Paying the death proceeds to those who have created and owned the premium fund is logical, and doing so puts the purchase money in the hands of those who own the life insurance proceeds. Simply, the surviving partners are obligated to buy the deceased’s interest in the partnership, and now they have the funds to do so. However, the surviving partners should not be the beneficiaries of the insurance proceeds when an entity plan is used.</span></li>
<li><span><strong>The deceased partner’s estate can be designated as beneficiary</strong>. If this beneficiary arrangement is made, the buy-sell agreement must clearly state that the insurance proceeds the estate receives are to be used to pay the purchase price of the deceased partner’s interest.</span></li>
<li><span><strong>Personal beneficiaries of the insured can be designated as beneficiaries</strong>. The objective of this arrangement is twofold. First, it is designed as business insurance to supply the purchase money for the deceased partner’s interest. Secondly, it is intended as personal insurance so that the purchase money remains in the form of insurance proceeds payable to the deceased’s family in installments under policy options.</span></li>
<li><span><strong>The partnership can be designated as beneficiary</strong>. The only occasion for this type of arrangement is the entity plan.</span></li>
</ul>
<span>Possible Problems of the Partnership Buy-Sell Agreement</span>
<p><span>The partnership business continuation plans discussed up to this point have been suitable in most cases. However, not all circumstances are typical, and sometimes the buy-sell agreement must be modified. A discussion of some of these problems follows.</span></p>
<span>Partners with Disproportionate Interests</span>
<p><span>In some partnerships, the interests are not equal or even close to being equal. For example, suppose one partner holds a 75 percent interest in the partnership, and the other partner owns 25 percent. The standard procedure for premium payment requires the partner with the smaller interest to purchase insurance on the life of the partner with the greater interest and pay these premiums. If this arrangement can be made, it is the best possible situation. These are the actuarially correct amounts that the partner with the smaller share should pay for.</span></p>
<p><span>However, often the partner with the greater interest is older, and sometimes the partner with the smaller interest cannot afford such premiums. In other cases, this arrangement simply seems unfair. Although many formulas can be used to devise a satisfactory solution to this situation, the partnership entity plan is probably the simplest.</span></p>
<span>The Uninsurable Partner</span>
<p><span>If an uninsurable partner has sufficient personal insurance that he or she is willing to sell and to assign to the partnership, then being uninsurable does not pose a problem. Or, the other partners could finance the purchase price of the insurable partner’s interest.</span></p>
<p><span>Alternatively, the partners other than the uninsurable member could deposit annually into a reserve fund an amount equal to what the life insurance premiums would have been. Then this fund could be soundly invested.</span></p>
<span>Liabilities of Large Partnerships</span>
<p><span>Some partnerships have relatively large liabilities. One remedy is a special joint policy of life insurance covering the partners in the amount of the obligations, with the face amount payable at the death of the first partner to die.</span></p>
<p><span>If a trustee is used, the policy could be made payable to the trustee with instructions to apply the proceeds to the debts.</span></p>
<span>Tax Issues with the Buy-Sell Agreement</span>
<p><span>Insurance premiums are not a tax-deductible expense. If the buy-sell agreement is cross-purchase with the partners insuring each other, then the partnership can pay the premiums and charge an equal, or prorated amount to each partner as income. If the buy-sell agreement is entity-style where the partnership owns the policies, then the premiums still have to “pass through” to the partners. An agreement between the partners on the best approach that is acceptable to all is necessary before the buy-sell agreement is structured.</span></p>
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<h2>
<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">1 - </span><span id="ctl00_Layout_lblChapterName">The Corporation</span></h2>
<p><span id="ctl00_Layout_lblContent">To protect the continuity of the corporation, thoroughly understanding the fundamental nature of the corporation and how it operates is essential. Just as in a sole proprietorship and a partnership, the death of a corporation stockholder can pose many problems, which must be considered when arranging the continuation of the corporate business. This preplanning is in the best interest of everyone, including the deceased’s family and his or her estate, the employees of the business, and the surviving stockholders.</span></p>
<p><span id="ctl00_Layout_lblContent">This chapter describes these issues as well as other fundamental characteristics of corporations, including the ways in which a corporation is formed and approved, the types of corporations, property rights, liabilities, and the reasons for liquidating a corporation.</span></p>
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<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">2 - </span><span id="ctl00_Layout_lblChapterName">Defining a Corporation</span></h2>
<p><span id="ctl00_Layout_lblContent">Whenever a new business is established, involved parties must legally decide whether the enterprise should be operated in an unincorporated form, or whether it should be formed as a corporation. The corporation is the most complex of the business structures in our discussion.</span></p>
<p><span id="ctl00_Layout_lblContent">The corporation was first defined by Chief Justice Marshall of the United States Supreme Court. In his famous decision in 1819 in the case of Dartmouth College vs. Woodward, he stated that a corporation is “an artificial being, invisible, intangible, and existing only in contemplation of the law.” So, a corporation is a distinct legal entity that is separate from the individuals who own it.</span></p>
<p><span id="ctl00_Layout_lblContent">Over the years, however, this definition and similar ones have been severely criticized as overemphasizing the nature of a corporation as an artificial legal entity. Those who denounce this definition claim that it fails to properly emphasize the association of the natural persons who comprise the corporation. Although Chief Justice Marshall’s definition is the legal one, in everyday terms, the corporation can be thought of as a group of one or more people acting as a unit and vested with personality by the policy of law.</span></p>
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<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">3 - </span><span id="ctl00_Layout_lblChapterName">Considerations for Incorporating</span></h2>
<p><span id="ctl00_Layout_lblContent">In determining whether a corporation is a practical form of business operation, the following issues should be considered:</span></p>
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<li><span id="ctl00_Layout_lblContent">What is the size of the risk, that is, what is the amount of the investor’s liability for debts and taxes?</span></li>
<li><span id="ctl00_Layout_lblContent">What is the continuity of the life of the business if something happens to the principal or principals?</span></li>
<li><span id="ctl00_Layout_lblContent">Which legal structure ensures the greatest adaptability for administering the business?</span></li>
<li><span id="ctl00_Layout_lblContent">What is the influence of the applicable law?</span></li>
<li><span id="ctl00_Layout_lblContent">What are the possibilities of attracting additional capital?</span></li>
<li><span id="ctl00_Layout_lblContent">What are the needs for and the possibilities of attracting additional expertise?</span></li>
<li><span id="ctl00_Layout_lblContent">What are the costs and procedures in starting up the business?</span></li>
<li><span id="ctl00_Layout_lblContent">What are the tax advantages and disadvantages of the corporate structure?</span></li>
<li><span id="ctl00_Layout_lblContent">What is the ultimate goal and purpose of the enterprise?</span></li>
</ol>
<p><span id="ctl00_Layout_lblContent">In determining whether a corporation is a suitable form of operating a business, all factors must be considered in the context of the specific business operation. Many issues are tax-related; others are not. Only the owners can decide which entity form offers the greatest advantages and the fewest disadvantages to them.</span></p>
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<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">4 - </span><span id="ctl00_Layout_lblChapterName">How a Corporation is Formed</span></h2>
<p><span id="ctl00_Layout_lblContent">A corporation can be created only by sovereign authority. This authority rests on the state and federal government. Those businesses that are set up in the District of Columbia are chartered by the federal government. Otherwise, corporations are chartered by the state in which they are formed. Corporations that do business in more than one state must comply with the laws of that state, which may vary considerably, as well as with federal laws regarding interstate commerce.</span></p>
<p><span id="ctl00_Layout_lblContent">In contrast, a sole proprietorship is formed by simply joining the components necessary to operate a particular business. The owner obtains the required licenses and permits and opens up shop. Equally simplistic is how partnerships are created—by the voluntary oral or written agreement of all of the partners.</span></p>
<p><span id="ctl00_Layout_lblContent">Although establishing a corporation can be complex and is certainly more complex than that of a sole proprietorship or a partnership, at least the procedures for creating a corporation are well-defined. The organizers of the corporation must prepare a<strong>Certificate of Incorporation </strong>or <strong>Articles of Incorporation</strong>. These articles are also referred to as the <strong>charter</strong>, or the <strong>bylaws</strong>. These articles state the powers and the limitations of the particular enterprise, and they must be signed by at least one incorporator.</span></p>
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<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">5 - </span><span id="ctl00_Layout_lblChapterName">The Model Business Corporation Act</span></h2>
<p><span id="ctl00_Layout_lblContent">A corporation is created by its Articles of Incorporation. They define the corporation’s essential characteristics and basic structure. This “character,” as it is called, must be submitted and approved by the state before the corporation’s legal existence can begin.</span></p>
<p><span id="ctl00_Layout_lblContent">The Model Business Corporation Act was prepared by the American Bar Association, and it sets forth the required contents of a character. The act is intended to serve as a guide for revising state business corporation laws. When adopted by a state, the provisions of the Model Business Corporation Act apply to all existing corporations.</span></p>
<p><span id="ctl00_Layout_lblContent">The required articles of incorporation are</span></p>
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<li><span id="ctl00_Layout_lblContent"><strong>a description of the corporation’s stock</strong>, that is, the number of shares, how many classes of shares exist, and the par value of the shares (“par” means equal; par value equals the established value).</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>classes of share</strong>, that is, the name of each class, its preferences, voting powers, limitations, restrictions, qualifications, and special or relative rights.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>series of classes</strong>, that is, the portion of a class of shares issued with a certain dividend rate, redemption privileges, liquidation preferences, conversion privileges, etc.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>pre-emptive rights</strong>, that is, the stock holder’s right to buy a portion of any new stock of the same class authorized and issued by the corporation.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>any special provisions</strong>.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the address of the initial registered office of the corporation </strong>and the name of its initial registered agent.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the names and addresses </strong>of the members of the corporation’s initial Board of Directors.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>one or more incorporators</strong>, either “natural persons” or another corporation, domestic or foreign. (All incorporators do not need to be residents of the state of incorporation). Usually the state statutes specify the number of incorporators or directors a corporation must have. Typically, a minimum number of these must be citizens of the United States and residents of the state of incorporation.</span></li>
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<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">6 - </span><span id="ctl00_Layout_lblChapterName">Corporation Approval</span></h2>
<p><span id="ctl00_Layout_lblContent">The approval for the corporation is in the form of a completed certificate that is sent to the proper state official, or division, for approval. Incorporation taxes and fees must be paid at this time. Upon approval, a new corporation is created.</span></p>
<p><span id="ctl00_Layout_lblContent">Often, the incorporator does not have to be a stockholder. When this is the case, the corporation needs at least one stockholder to proceed with the election of the Board of Directors. The corporation becomes fully developed after the first meeting of the incorporators and directors. At this meeting, the bylaws that govern the corporation are adopted, and officers are elected. Now the corporation is ready to begin its business.</span></p>
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<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">7 - </span><span id="ctl00_Layout_lblChapterName">The Corporate Name</span></h2>
<p><span id="ctl00_Layout_lblContent">When forming a corporation, the organizers must decide on a corporate name. Federal law requires that the name of the corporation must include the words “corporation,” “company,” “incorporated,” “limited,” or an abbreviation of one of these.</span></p>
<p><span id="ctl00_Layout_lblContent">The purpose of this requirement is so that people who are not familiar with the corporation are made aware that they are dealing with an entity to which no individual can be held personally liable. For example, if the corporate business is unable to pay its debts or obligations, no individual can be personally liable to pay these debts, as can be the case in a sole proprietorship or a partnership. The exception to this liability protection is if an officer or director personally guarantees a loan or debt, or if criminal activity is present.</span></p>
<p><span id="ctl00_Layout_lblContent">Further, the corporate name must accurately describe what the business does. Its name cannot mislead the public with respect to what the corporation does or does not do. Also, the name of a new corporation cannot resemble or approximate any other corporation that does business within the same jurisdiction.</span></p>
<p><span id="ctl00_Layout_lblContent">When forming a corporation, the organizers must subscribe for capital stock. Shares in a corporation are generally considered securities within the meanings of state and federal securities laws.</span></p>
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<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">8 - </span><span id="ctl00_Layout_lblChapterName">Selecting the Tax Status of a Corporation</span></h2>
<p><span id="ctl00_Layout_lblContent">Once the corporation receives registration approval in the state of domicile, it must file with the Internal Revenue Service for a tax identification number. This tax I.D. number is specific to that corporation and identifies the corporation as an entity for tax purposes. Application for the tax I.D. number is required before the corporation can establish a banking account, vendor arrangements, or can initiate any form of business activity.</span></p>
<p><span id="ctl00_Layout_lblContent">The incorporators or Board of Directors decide the tax status of the corporation. The corporation can select from two definitions of tax status:</span></p>
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<li><span id="ctl00_Layout_lblContent">Any corporation is considered a C corporation that has a graduated tax schedule, similar to that which would apply to an individual income tax schedule. The C corporation also has a defined set of tax guidelines.</span></li>
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<p><span id="ctl00_Layout_lblContent">An election to be taxed other than a C corporation is available through an election when applying for the corporate tax I.D. number. This election allows the corporation to be taxed as an S corporation.</span></p>
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<ol>
<li value="2"><span id="ctl00_Layout_lblContent">Under the S corporation election, a corporation is referred to as a Sub-S corporation and is not subject to an individual tax schedule, as is the C corporation. Profits and losses of an S corporation pass through to a certain class of stockholders as defined by the corporate charter. This “pass through” characteristic is similar to that of how a partnership is taxed. However, the S corporation acquires certain tax benefits in how income can be designated, as well as how other issues of income and expenses are treated.</span></li>
</ol>
<p><span id="ctl00_Layout_lblContent">The primary difference between the C corporation and the S corporation with respect to life insurance planning issues is that the C corporation has its own tax obligation, which is referred to as a <strong>“closed gate” </strong>in keeping certain expenses within the corporate tax venue. Conversely, the S corporation, having no individual tax obligation, has an <strong>“open gate” </strong>through which profits and losses pass through to the stockholders.</span></p>
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<h2>
<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">9 - </span><span id="ctl00_Layout_lblChapterName">Types of Corporations</span></h2>
<p><span id="ctl00_Layout_lblContent">Corporations fall into many broad classifications. The attributes of any corporation can vary according to its character, which is generally determined by the nature of the business of the corporation as stated in its articles of incorporation. The nature and the character of a corporation, as disclosed by its character, cannot be changed or enlarged in excess of its powers.</span></p>
<p><span id="ctl00_Layout_lblContent">Generally, corporations are classified as <strong>public </strong>or <strong>private</strong>. This distinction refers to the powers of a particular corporation and to the purpose of its creation. A public corporation is a government body, for example, a state or political subdivision of a state. A private corporation is a non-governmental body and is further divided between a <strong>non-stock corporation </strong>and a <strong>stock corporation</strong>.</span></p>
<p><span id="ctl00_Layout_lblContent">Non-stock corporations are usually divided into various types of membership, including religious and charitable organizations. Stock operations are those that have capital stock. Capital stock is divided into <strong>shares</strong>. The corporation is empowered by law to distribute dividends, or shares of surplus profits, to its stockholders. Stock corporations can be further classified as <strong>financial corporations</strong>, such as bank and insurance companies; <strong>public service corporations</strong>; <strong>business corporations</strong>; or <strong>professional corporations</strong>.</span></p>
<p><span id="ctl00_Layout_lblContent">Further classification comes from defining the business corporation as a <strong>publicly held corporation </strong>or a <strong>close corporation</strong>. A publicly held corporation is one in which its stock is traded on one of the open exchanges. This type of corporation is characterized by being owned by a substantial number of stockholders, most of whom take no part in the active management of the corporate business.</span></p>
<p><span id="ctl00_Layout_lblContent">On the other hand, a close corporation is a private corporation, or privately held, and its stock is not openly traded. A close corporation is also referred to as a closely held corporation. The close corporation is our central topic of discussion with respect to<strong>business continuation plans</strong>.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">The Close Corporation</span></h3>
<p><span id="ctl00_Layout_lblContent">A close corporation is a corporation whose franchise is owned by a small group of stockholders. Generally, these stockholders are actively engaged in the management of the corporation. Often, the entire corporation consists of only the Board of Directors, officers, and shareholders. Typically the management of this type organization is in the hands of a small group of people.</span></p>
<p><span id="ctl00_Layout_lblContent">In many jurisdictions, special statutes have been enacted to permit single individuals to form a close corporation. Whether a small group or a single individual, in forming a close corporation, the members limit their personal liability, but they conduct business without the formality often required by other types of corporations.</span></p>
<p><span id="ctl00_Layout_lblContent">A single stockholder or a very small number of stockholders generally hold the outstanding shares of stock in close corporations. Frequently, these stockholders are family and relatives, so the relationship between the management and the principal stockholders is very close. Because of the nature of the closely held corporation, the stockholders have a good knowledge of the corporation and of each other. In addition, these stockholders often have voting rights with respect to the activities of the corporation. They can choose to prohibit the transfer of shares to persons who are not family members or who are not employees of the corporation.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Characteristics Of A Close Corporation</span></h4>
<p><span id="ctl00_Layout_lblContent">The following factors generally characterize a close corporation:</span></p>
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<ul>
<li><span id="ctl00_Layout_lblContent">a small number of stockholders</span></li>
<li><span id="ctl00_Layout_lblContent">the recognition of partnership-like relationships</span></li>
<li><span id="ctl00_Layout_lblContent">the provision of minimum corporate formality</span></li>
<li><span id="ctl00_Layout_lblContent">no ready market for the shares of the corporation</span></li>
<li><span id="ctl00_Layout_lblContent">shareholder knowledge of the corporation</span></li>
<li><span id="ctl00_Layout_lblContent">the recognition of the autonomy of the participants in a close corporation to achieve contractually desirable arrangements</span></li>
<li><span id="ctl00_Layout_lblContent">a tight relationship between management and the principle stockholders and the stockholders’ desires for involvement in the voting process</span></li>
<li><span id="ctl00_Layout_lblContent">the provisions for certain dispute resolution techniques, such as provisional directors and optional dissolution by a stock holder</span></li>
<li><span id="ctl00_Layout_lblContent">the ease of enforcement of arrangements to preserve the close corporation status under a stockholders agreement</span></li>
<li><span id="ctl00_Layout_lblContent">generally subject to broad transfer restrictions.</span></li>
<li><span id="ctl00_Layout_lblContent">the operation and relationship of the stockholders to each other typically resemble partnerships rather than traditional corporations.</span></li>
</ul>
<h4>
<span id="ctl00_Layout_lblContent">Close Corporation Statutes</span></h4>
<p><span id="ctl00_Layout_lblContent">The statutes addressing close corporations are generally of two distinctions:</span></p>
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<ul>
<li><span id="ctl00_Layout_lblContent">They are statutes that are simply a part of general corporation laws, although they authorize provisions in corporation charters to modify the traditional corporate structure to fit the needs of the closely held business.</span></li>
<li><span id="ctl00_Layout_lblContent">They are statutes that are entirely devoted to the issues of close corporations.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">To take advantage of close corporation status, most states require that a close corporation must state its intent in its articles of incorporation to be considered a closely held corporation. Many modern statutes actually bar close corporations’ securities from the exchanges or from the over-the-counter market. The close corporations are required to make their restrictions explicit on the transfer of shares by agreements, and they must limit their number of stockholders.</span></p>
<p><span id="ctl00_Layout_lblContent">Many statutes define the various ways in which participants in close corporations can shape their arrangement to suit their needs. For example, close corporation founders can arrange matters so that persons contributing skill and efforts rather than cash have a larger say.</span></p>
<p><span id="ctl00_Layout_lblContent">Also, the members of a close corporation operate under the assumption that the membership is limited. Therefore, any changes in ownership can be traumatic, and special provisions for the transfer of stock may be necessary.</span></p>
<p><span id="ctl00_Layout_lblContent">Further, in some states, those forming a close corporation can reject one or all of the assumptions that the law typically makes about allocating control in an ordinary corporation.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">The Close Corporations vs. the Partnership</span></h4>
<p><span id="ctl00_Layout_lblContent">As in a partnership, a few individuals have a very close relationship in a close corporation. These individuals combine their talents and skills in conducting a business enterprise.</span></p>
<p><span id="ctl00_Layout_lblContent">Because a close corporation is generally small, each of the stockholders is usually a director and/or an officer, making the corporation a going concern in his or her life. The close corporation is a great investment for stockholders. As with the death of a partner, if a stockholder dies, his or her survivors would be eager for the corporation to continue. In fact, it is likely vital to them that the corporation continue.</span></p>
<p><span id="ctl00_Layout_lblContent">Also similar to partnerships, stockholders in a close corporation often conduct themselves and their business affairs like partners. In fact, it is not uncommon for them to refer to themselves as partners. Some courts have even applied partnership law to resolving disputes in closely held corporations. In recent years, the courts have relaxed their attitudes with respect to the statutory compliance of close corporations. They permit some deviations in their behavior from traditional corporate norms.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Limited Liability Considerations for Closed Corporations</span></h4>
<p><span id="ctl00_Layout_lblContent">Corporations have the benefit of limited liability. Although this limited liability is an advantage for larger organizations, the benefits for a closely held corporation are not so great. For example, with respect to bank loans, lease obligations, and major suppliers, owners and stockholders in a close corporation are often asked to personally guarantee any credit extended. Their limited liability is often waived.</span></p>
<p><span id="ctl00_Layout_lblContent">Further, the corporation does not limit the liability of a stockholder for his or her own wrongful acts or omissions. Therefore, the stockholder can be held personally liable for the full amount of losses or damages resulting from these wrongful acts or omissions.</span></p>
<p><span id="ctl00_Layout_lblContent">Sometimes whether a close corporation should be incorporated at all is questioned. While questions of liability and continuity may suggest that partners in a partnership should incorporate and form a close corporation, tax factors could suggest that a close corporation should become a partnership. Some businesses try to use both forms of organizations, attempting to gain all of the advantages of both forms of organizations, while at the same time rejecting the disadvantages of either.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Fiduciary Duty of Closed Corporations</span></h4>
<p><span id="ctl00_Layout_lblContent">The rules about fiduciary obligations are slightly different in the context of the close corporation. Remember that in a partnership, the fiduciary relationship between partners means that each partner owes complete loyalty to the partnership. He or she may not engage in any activity that conflicts with the interest of the partnership.</span></p>
<p><span id="ctl00_Layout_lblContent">This meaning often becomes blurred in a close corporation. Naturally, the distinctions between officers or directors and stockholders tend to lose their significance in small corporations. Frequently, these people are one of the same. Further, effective operations and rational decision-making are often hard to maintain in small corporations. But in a close corporation, some managers or stockholders could have their own interests at stake.</span></p>
<p><span id="ctl00_Layout_lblContent">This factor should be considered when planning the estates of stockholders in a close corporation and constructing the buy-sell agreement. While personal factors can occur in larger corporations, they are more prevalent in a typical close corporation. Personal motivations and feelings can often interfere with the objective performance of any duties, including fiduciary ones.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">10 - </span><span id="ctl00_Layout_lblChapterName">Rights and Powers of the Corporation</span></h2>
<p><span id="ctl00_Layout_lblContent">The powers of a corporation are those granted by the state, as found in the formal corporate charter and in applicable statutes; attributes of these rights and powers are listed below. The corporation’s only power is to conduct the type of business authorized by its charter.</span></p>
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<p> </p>
<p> </p>
<p> </p>
<p> </p>
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<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">The expressed powers on the corporation’s charter are often stated as broadly as possible. This avoids any question of engaging in acts beyond the scope of the charter.</span></li>
<li><span id="ctl00_Layout_lblContent">Generally, a corporation can be formed for any lawful purpose. Naturally, special statutes and requirements govern a corporation’s conduct with respect to banking, insurance, transportation, and other activities that are closely related to the public interest.</span></li>
<li><span id="ctl00_Layout_lblContent">A corporation has the power of continued existence during the period designated in its charter. It has the right to use its corporate name, and the power to change its name, subject to applicable laws. A corporation also has the right to use a corporate seal, although in most states, a corporate seal is not required.</span></li>
<li><span id="ctl00_Layout_lblContent">A corporation has the power to enter into all contracts necessary to conduct its business. It has the power to employ officers, employees, and agents to conduct its affairs.</span></li>
<li><span id="ctl00_Layout_lblContent">A corporation has the power to acquire and hold property for purposes that are consistent with the powers granted to it. It may borrow money, contract indebtedness, and furnish security for any debt.</span></li>
<li><span id="ctl00_Layout_lblContent">A corporation can sue and be sued in its corporate name.</span></li>
<li><span id="ctl00_Layout_lblContent">A corporation can make bylaws for governing its affairs, consistent with its formal charter and with applicable laws. It can enter into joint ventures, but a corporation cannot become a partner unless specifically authorized by its charter.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">Common law holds that, unless expressly authorized, a corporation has no right to purchase its own share of stock. However, the courts have held that a corporation does have the implied power to acquire its own shares, as long as it does so in good faith and without injury to its creditors or stockholders. To prevent such an injury, this purchase must be made from surplus.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">11 - </span><span id="ctl00_Layout_lblChapterName">Managing the Corporation</span></h2>
<p><span id="ctl00_Layout_lblContent">Centralizing management is an advantage of the corporation. Of course, the centralization of management can be accomplished in a partnership, too. However, in a corporation, the corporation statutes encourage the centralized approach.</span></p>
<p><span id="ctl00_Layout_lblContent">Stockholders elect directors who are responsible for managing the corporation. This Board of Directors elects officers who carry out the management policies. A president and a secretary are typically required, and other officers may be necessary, as well. The corporation’s articles of incorporation and the state statutes further define the rights and responsibilities of the directors, officers, and stockholders.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">The Stockholders</span></h3>
<p><span id="ctl00_Layout_lblContent">The stockholders in a large corporation have no authority to participate in the corporation’s ordinary business. In this way, they are often referred to as <strong>inactive stockholders</strong>. The operation of the corporation’s business is managed by the Board of Directors; the stockholders elect the directors. However, in a smaller close corporation, the stockholders are active participants in the corporation’s business. These types of stockholders are referred to as <strong>active stockholders</strong>.</span></p>
<p><span id="ctl00_Layout_lblContent">In addition to electing the Board of Directors, the stockholders participate in various decisions that relate to the existence, powers, and capital structure of the corporation. These decisions include approving the disposal of the aggregate corporate assets, approving a mortgage on the corporate property, amending the corporate charter or effecting any changes in the capital stock, approving the dissolution of the corporation, and approving any consolidation or merger.</span></p>
<p><span id="ctl00_Layout_lblContent">Sometimes stockholders render their decisions by majority vote. In some situations, for example, in the mortgaging of the corporation’s realty, a vote of two-thirds or greater is usually required by statute. Some states require that stockholders must vote before a corporation can purchase its own stock, and the percentage necessary to secure this approval is specified.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">The Board of Directors</span></h3>
<p><span id="ctl00_Layout_lblContent">After the election by the stockholders, the Board of Directors meets and proceeds with the management of the ordinary affairs of the corporation. However, a board member has no individual authority to act for the corporation; he or she only acts as a Board with the other members when they are assembled at an official meeting of the board.</span></p>
<p><span id="ctl00_Layout_lblContent">The Board of Directors elects corporate officers, and their salaries are fixed by the Board. Then the officers proceed by hiring agents and employees to execute the daily business of the corporation. Although the Board of Directors can delegate to officers and agents, they can delegate only ministerial power to administer the affairs of the corporation. For example, the Board cannot delegate discretionary powers.</span></p>
<p><span id="ctl00_Layout_lblContent">While the Board members are not exactly considered trustees, they do hold a fiduciary relationship to the corporation and to its stockholders. They are obligated to exercise the same degree of care and prudence in conducting its affairs as would be exercised by an ordinary prudent person in conducting his or her affairs. Further, a director cannot exercise his or her official position for his/her own benefit; the director must act only for the benefit of the corporation. The corporate assets must not be wasted or misapplied.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">The Officers</span></h3>
<p><span id="ctl00_Layout_lblContent">The Board of Directors acts only in official meetings. Because these meetings obviously cannot be held continually, the Board delegates duties on behalf of the corporation to officers. Corporate officers are elected by the Board of Directors.</span></p>
<p><span id="ctl00_Layout_lblContent">The duties of each officer are typically specified in the bylaws of the corporation. The offices usually consist of a president, at least one vice president, a secretary, and a treasurer. It is the duty of these officers to carry on the business of the corporation. This includes hiring and supervising the agents and employees of the corporation.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">12 - </span><span id="ctl00_Layout_lblChapterName">Property Rights in a Corporation</span></h2>
<p><span id="ctl00_Layout_lblContent">As described earlier, a corporation is an entity separate and distinct from those who participate in it. So exactly who holds the title to the assets of a corporation? This title is vested in the corporation as a legal entity. For example, suppose a small gift store is formed as a close corporation, and there are only two stockholders. Which of the two actually owns the inventory? Do they share ownership? When a crystal clock is sold to a customer, who is the seller?</span></p>
<p><span id="ctl00_Layout_lblContent">The answer to these questions is that the inventory is held in the corporate name. When the crystal clock is sold, it is sold by the corporation acting through its authorized representatives. Neither of the two stockholders actually has any legal ownership in the inventory. If someone should unlawfully possess any of the inventory, it can be recovered only in the name of the corporation.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">13 - </span><span id="ctl00_Layout_lblChapterName">The Assets of the Corporation</span></h2>
<p><span id="ctl00_Layout_lblContent">The assets of a corporation are owned by the corporation and not by the stockholders, officers, or Board of Directors. So, if one of the participants in the gift store corporation described earlier wanted to own the crystal clock, he or she would purchase it from the corporation. Alternatively, he or she could receive it as a dividend, but this person would still have to receive title to the clock from the corporation.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">14 - </span><span id="ctl00_Layout_lblChapterName">The Interest of Each Stockholder</span></h2>
<p><span id="ctl00_Layout_lblContent">Although no person can own property in connection with a corporation, persons do own other rights, namely intangible rights. Stockholders collectively own the “franchise of the corporation to be a corporation.” The primary franchise of being a corporation is a special privilege conferred by the state. This special privilege vests in the group of individuals who comprise the corporation.</span></p>
<p><span id="ctl00_Layout_lblContent">A stockholder has the following rights:</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>the right to receive dividends</strong>—Stockholders also own the rights accruing to one who holds a share in a stock corporation. A share of the capital stock is the right to partake, according to the amount put into the fund, in the surplus profits of the corporation. This is the right to share in dividends when they are declared by the Board of Directors. Dividends are corporation funds that are obtained from the earnings and profits of the corporation and that are appropriated by a corporate act. These dividends are divided among the stockholders. Dividends are declared by the Board of Directors.</span></li>
</ul>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">Two rights comprise a share of stock:</span>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span id="ctl00_Layout_lblContent">The right to receive a fractional share of surplus profits in the form of dividends when they are declared</span></li>
<li><span id="ctl00_Layout_lblContent">The right to receive a like share of the residuals upon the dissolution of the corporation</span></li>
</ol>
</li>
</ul>
<p> </p>
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<ul>
<li><span id="ctl00_Layout_lblContent"><strong>the right to transfer stock interest and to have the transfer made on the corporate books </strong>A stockholder has the property right to transfer his or her shares at will. However, the right can be circumvented by the corporate charter or by means of some contract between the stockholders. This right can be circumvented only within reason. An absolute prohibition against transferring stock, however, is invalid, because it goes against public policy. The courts look more favorably upon restricting the transfer of close corporation stock than upon restricting the stock of publicly held corporations.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the right to inspect the books and records of the corporation</strong>—This right is conferred by common law and in most states, by statute. A stockholder has a right to inspect the books and records of the corporation at reasonable times and places and for proper purposes. Most states grant this right, regardless of the motive or the purpose behind the inspection. This right can be exercised in person or by the stockholder’s authorized agent or attorney. Copies can be made of the books and records.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the right to attend stockholders’ meetings and to vote for directors</strong>—All stockholders have the right to attend stockholder meetings and to vote on corporate matters. In some situations, the right to vote by proxy is conferred by state statute or by the corporation’s bylaws. In a stockholders meeting, shareholders represent themselves and their own interests, and they may vote as they desire. One vote is generally allowed for each share of voting stock.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the right to adopt bylaws</strong></span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the right to receive a certificate as evidence </strong>of his or her share of the stock</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the right to require that the property of the corporation be employed for proper corporate purposes</strong></span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the right to subscribe for any new shares of stock</strong></span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the right to vote on such matters as the change of corporate name</strong>, the change in the capital structure of the corporation, or any other material change</span></li>
</ul>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">15 - </span><span id="ctl00_Layout_lblChapterName">Liabilities in a Corporation</span></h2>
<p><span id="ctl00_Layout_lblContent">The most commonly cited non-tax-related advantage of operating a business as a corporation is the ability to enjoy the protection of limited liability. Usually, this is the primary consideration. Because a corporation is regarded as a distinct legal entity separate and apart from its stockholders, a corporation enjoys a limited liability that is not afforded by the formation of a sole proprietorship or a partnership. Sole proprietors are liable to the full extent of their personal assets to the creditors of their unincorporated business, as are partners in a partnership.</span></p>
<p><span id="ctl00_Layout_lblContent">Sole proprietors are personally liable to the full extent of their assets by creditors for business-related acts or omissions committed by themselves, by their employees, and by their agents. Likewise, a partner is personally liable for these as well as for those acts or omissions of another partner.</span></p>
<p><span id="ctl00_Layout_lblContent">A stockholder, on the other hand, is not personally liable for the debts and obligations of the corporation or for the acts of fellow stockholders, corporate directors, officers, employees, or agents. The stockholder of a corporation is liable for contractual obligations only to the extent of his or her investment in the corporation.</span></p>
<p><span id="ctl00_Layout_lblContent">Although a corporation can be sued, the corporation is the proper defendant to a lawsuit, not the stockholders. This rule does have a few exceptions: under some circumstances, the corporate entity is disregarded, but this usually happens only in case of fraud.</span></p>
<p><span id="ctl00_Layout_lblContent">In some cases limited liability is overstressed as a benefit of incorporation. To remedy the liability issue, sole proprietors and partners can take out liability insurance to cover most risks, thereby limiting their liability with an insurance policy. Any risk of loss that owners of non-corporate organizations may experience from wrongful acts or omissions can be substantially reduced by this insurance in the ordinary course of business. Liability can be circumvented.</span></p>
<p><span id="ctl00_Layout_lblContent">In some organizations, the nature of the business is such that risk of loss cannot be adequately insured. This could include hazardous enterprises where liability insurance is either unavailable or prohibitively expensive. Naturally, in these cases, limited liability is a crucial factor.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">Express, Implied, and Apparent Authority</span></h3>
<p><span id="ctl00_Layout_lblContent">A corporation can be held liable for all acts of its officers, agents, and employees performed within the general powers of the corporation and with the express or implied authority of the corporation. A corporation has two types of authority: (1) <strong>express actual authority </strong>and (2) <strong>implied actual authority</strong>. Express actual authority is authority actually bestowed. Typically, express authority originates from the decisions made by a majority of the stockholders.</span></p>
<p><span id="ctl00_Layout_lblContent">Implied actual authority includes authority that is neither expressly granted nor expressly denied. Implied authority is reasonably deduced from the nature of the business.</span></p>
<p><span id="ctl00_Layout_lblContent">If an authorized corporation representative enters into a contract that is beyond the express actual or implied actual authority of a corporation, an <strong>ultra vires contract</strong>exists. An ultra vires contract is one that is beyond the scope or powers of the corporation. Such a contract cannot be enforced against the corporation, unless the other party has already performed and the corporation has received some benefit from the contract.</span></p>
<p><span id="ctl00_Layout_lblContent">Further, just because an act is committed in the course of an ultra vires transaction does not relieve the corporation of liability.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">Liability of Officers, Agents, and Employees</span></h3>
<p><span id="ctl00_Layout_lblContent">When representatives act for a corporation, they assume no personal liability if their act is within their authority or if their act is validated by the corporation. However, without validation or express or implied authority, the representative can be liable to the corporation for any damages. The representative can also be held liable to the other party for breach of implied warranty or authority.</span></p>
<p><span id="ctl00_Layout_lblContent">If a representative of a corporation commits an act such as negligent or willful injury to another while he or she is acting within the scope of his or her authority, the representative and the corporation can be held liable for any resulting damages.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">Liability of the Directors</span></h3>
<p><span id="ctl00_Layout_lblContent">As described earlier in this chapter, a corporation’s directors are obliged to exercise the same degree of care and prudence in managing the corporation as they would use in handling their own affairs. Directors must be honest and diligent in performing their duties. As such, when any mistakes, omissions, or errors in judgment are made, directors can be held liable. They can also be held liable for damage or injury to the corporation that results from their failure to act, their failure to act with reasonable prudence, or their negligent or willful acts that are adverse to the corporation’s welfare.</span></p>
<p><span id="ctl00_Layout_lblContent">In some states, laws impose statutory liability upon directors and officers for breach or neglect of certain duties; for example, the failure to make a required report. Statutory liability is created by the legislative or executive branches of government. Laws, statutes, or other rulings are enacted, and these create the liability exposure. On the other hand, common law liability stems from the body of law that is created in the courts. Common law is not written, legislated, or upheld by statutes. Rather, it is based on written judicial decisions known as <strong>precedent</strong>.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">Liability of the Stockholders</span></h3>
<p><span id="ctl00_Layout_lblContent">Stockholders as a classification are not actively involved in managing a corporation. Therefore, they have no liability for acts of the corporation. Generally speaking, stockholders are not liable for the debts of their corporation. So, if a corporation should become insolvent, in the absence of any special statutory liability, a stockholder stands to lose only his or her capital investment.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Defining Active Stockholders</span></h4>
<p><span id="ctl00_Layout_lblContent">An active stockholder is one who is engaged in some form or another in the daily business operations of the corporation. They can serve on the Board of Directors, in the role of officer or agent of the corporation, in a full- or part-time capacity, or in any capacity of engagement.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Defining Inactive Stockholders</span></h4>
<p><span id="ctl00_Layout_lblContent">An inactive stockholder is one who has provided invested capital by purchasing corporate stock but takes no active role in the daily business operations of the corporation. The only participation of the inactive stockholder is in electing the Board of Directors, attending stockholder meetings as they are scheduled, and voting on issues that may be presented to the stockholders.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">The Death of a Stockholder</span></h4>
<p><span id="ctl00_Layout_lblContent">Within the true meaning of the corporation, the corporation’s Articles of Incorporation typically provide for its perpetual existence. Its succession is continued for the period specified by its charter or by statute. Because a corporation is treated as a separate entity with continuity of life, events such as the death of an owner really have no effect on the legal structure of the corporation.</span></p>
<p><span id="ctl00_Layout_lblContent">However, this is not to say that the death of a stockholder has no effect at all on the corporation. Even though the death of a stockholder has no legal effect on the existence of the corporation, as in a sole proprietorship or a partnership, the death of a stockholder has other consequences, which can be specified in a shareholder agreement. Of course, these consequences depend on whether the deceased stockholder was a sole stockholder, a majority stockholder, minority stockholder, equal stockholder, inactive stockholder, or active stockholder.</span></p>
<p><span id="ctl00_Layout_lblContent">Still, the corporation’s legal existence is not displaced by any changes in the ownership of its shares of stock. Shares in a corporation can be passed to heirs, because they are personal property.</span></p>
<h5>
<span id="ctl00_Layout_lblContent">Retaining the Corporate Interest</span></h5>
<p><span id="ctl00_Layout_lblContent">After the death of a stockholder in a larger corporation or in a publicly held corporation, the deceased can bequeath his or her shares in the corporation to his or her heirs. This has no real effect on the continuity of the corporation.</span></p>
<p><span id="ctl00_Layout_lblContent">Unfortunately, in a closely held or smaller corporation, the business can suddenly be without the skills, knowledge, abilities or talents of an important individual who is not easily replaceable. The result is that the corporate entity can be unnerved. It may be in jeopardy, and the confidence of the clientele can be seriously weakened. Some immediate options upon the death of a stockholder are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">the surviving stockholders can decide to continue the corporate enterprise with the heirs of the deceased stockholder as a part of management;</span></li>
<li><span id="ctl00_Layout_lblContent">the surviving stockholders may want to purchase the stock of the deceased;</span></li>
<li><span id="ctl00_Layout_lblContent">the surviving stockholders may consider selling their own interests.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">From the standpoint of the heirs, if they want to sell their newly acquired stock, they may learn that neither the corporation nor the remaining shareholders are financially capable of buying them, and the stock has no established market. In these circumstances, the heirs have no choice other than to retain the stock and to play an active role in the business.</span></p>
<p><span id="ctl00_Layout_lblContent">To ensure the financial security of the corporate owners and their families, preplanning and a buy-sell agreement can play important roles. The provisions of the agreement must be tailored to satisfy the requirements and the objectives of the stockholders, as well as those of the corporation. The purpose of such an agreement is to provide the funds necessary so that the deceased’s interest can be purchased and to provide a way that the business can continue in a smooth and uninterrupted manner.</span></p>
<h5>
<span id="ctl00_Layout_lblContent">The Death of a Sole Stockholder</span></h5>
<p><span id="ctl00_Layout_lblContent">The death of a close corporation stockholder can have a severe impact, even though his or her death does not affect the legal existence of the corporation. Even more debilitating is the death of a sole stockholder, which makes administering an active business even more challenging than it already is. When a sole stockholder dies, he or she essentially leaves his or her estate and heirs in a predicament similar to that found in a sole proprietorship or partnership. For example, the personal representative immediately takes possession of all of the deceased’s assets to conserve them and to apply them to the payment of all debts, business and personal. The personal representative must ensure that the remaining property of the estate is then distributed to those who are entitled to it.</span></p>
<p><span id="ctl00_Layout_lblContent">The personal representative has no authority to continue the business of the corporation and must promptly dispose of it or dissolve it. If a personal representative, especially one who is unfamiliar with operations, continues the business without authorization, then the estate values are often significantly reduced.</span></p>
<p><span id="ctl00_Layout_lblContent">In the context of the corporation’s business, the personal representative has the right to receive dividends that may be declared on the shares of the company. Further, personal representatives have the right to vote upon the shares, but their possession of these rights is purely fiduciary. Therefore, they are answerable to the beneficiaries for their conduct in relation to these assets, as well as in all other assets held in their trust.</span></p>
<p><span id="ctl00_Layout_lblContent">Without the benefits of preplanning, any attempts to maintain the continuity of the close corporation business are only accomplished through a post-mortem plan.</span></p>
<h5>
<span id="ctl00_Layout_lblContent">Issues for the Heirs and the Estate of a Sole Stockholder</span></h5>
<p><span id="ctl00_Layout_lblContent">If the sole stockholder does not, prior to his or her death, make arrangements for the future of his or her corporation, then the personal representative is required to sell or to liquidate the business. If the corporation is a successful one, sometimes the personal representative or the heirs attempt to keep the business operating, despite the lack of authority to do so.</span></p>
<p><span id="ctl00_Layout_lblContent">Sometimes it is difficult to determine whether a continuation of the corporation is authorized. In one respect, the personal representative has the duty to conserve the estate’s assets. But in another respect, the personal representative is penalized if he or she continues the business without authority. Moreover, sometimes the heirs request that the personal representative continue the corporation business, giving their consent to this. However, such continuation is considered to be unauthorized.</span></p>
<p><span id="ctl00_Layout_lblContent">Even if all heirs are competent adults, the personal representative must obtain unanimous consent to keep the business operating. If all of the heirs are of age, competent, and willing to consent, and if profits result, the personal representative must turn the profits over to the estate. However, if losses are sustained as a result of continuing the business, then the consenting heirs have surrendered their right to hold the personal representative liable. Not having an effective business continuation plan can cause the heirs to forfeit their legal right to hold the personal representative to account.</span></p>
<p><span id="ctl00_Layout_lblContent">In most states, authority can be granted to the personal representative to carry on the business temporarily. If the business is to be continued under the authority of a state statute, it is likely to be permitted to continue only as long as is necessary to wind up the work in progress and to wind up the affairs of the business. Even a court order does not allow the business to run indefinitely.</span></p>
<p><span id="ctl00_Layout_lblContent">Some statutes permit the continuation of a business for the purpose of its sale as a going concern during the normal period of estate administration. A few states permit the personal representative to continue the deceased’s business until a sale can be made, even though it cannot be made during the normal period of estate administration. However, favored business conditions must exist for such a statute to apply. Favored business conditions mean that the business is profitable as an ongoing concern; a good business climate and/or market exists.</span></p>
<h5>
<span id="ctl00_Layout_lblContent">The Absence of Wills and Trusts of a Sole Stockholder</span></h5>
<p><span id="ctl00_Layout_lblContent">If the deceased sole stockholder does not have a will or living trust, the personal representative must dispose of the personal property of the estate for cash. If cash or other property exists that is sufficient to pay the debts, taxes, and administration expenses, then the personal representative can conserve the deceased sole stockholder’s stock for the beneficiaries of the estate. Difficulty can arise, however, if any of the heirs are minors.</span></p>
<p><span id="ctl00_Layout_lblContent">Although it may be the intent of the personal representative to get the best price upon liquidation of an asset, a forced sale of the stock or the assets of the corporation under these distressing conditions can result in considerable loss of value to the estate and to the heirs. The personal representative is responsible for promptly administering the estate.</span></p>
<h5>
<span id="ctl00_Layout_lblContent">The Presence of Wills and Trusts of a Sole Stockholder</span></h5>
<p><span id="ctl00_Layout_lblContent">If the deceased sole stockholder does have a valid will or living trust, the language in the will or trust must specifically address the issue of his or her shares of stock. Authority can be given to the personal representative to operate the business until a suitable buyer is obtained, or assets of the corporation are sold at the best market price. Or, the stock can be placed in trust for the heirs and the beneficiaries of the estate, or can be bequeathed to one or more of the heirs of the estate.</span></p>
<p><span id="ctl00_Layout_lblContent">However, if these shares represent a majority of the value of the deceased’s assets in the estate, some portion of the shares will probably have to be sold to raise the funds for paying debts and other expenses.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">The Death of a Majority Stockholder</span></h4>
<p><span id="ctl00_Layout_lblContent">A close corporation is similar to a partnership in that it involves a close and intimate association of a few individuals who combine their talents and skills in the conduct of a business enterprise. In the event of the death of a partner, the legal entity that was formed as a result of the partnership ceases to exist. While the death of a majority stockholder does not affect the legal existence of the corporation as it would in a partnership, it can have dire consequences to the corporation.</span></p>
<h5>
<span id="ctl00_Layout_lblContent">Issues for the Heirs and the Estate of the Majority Stockholder</span></h5>
<p><span id="ctl00_Layout_lblContent">Initially, the shares of the deceased majority stockholder go to the personal representative who holds them during the time of administration of the estate. This is done for the benefit of the creditors and the heirs or beneficiaries. The majority stockholder is usually the person who contributes a particular vital skill to the close corporation or who was the primary source of capital and credit. He or she was a valuable member of the corporate crew, and the corporation will likely suffer as a result of his or her death.</span></p>
<p><span id="ctl00_Layout_lblContent">Unlike a partnership, where the surviving partners can wind up the partnership, seek a new partner, or reconstitute the partnership with only the surviving partners, the corporation has perpetual life, binding the minority stockholders to an uncertain future. This can create a hostile or unfriendly environment that affects the ongoing operations of the business. The personal representative is responsible for managing all of the assets of the deceased majority stockholder’s estate. The uncertainty of the minority stockholders, officers, and employees may make the prospect of maintaining a going concern difficult.</span></p>
<p><span id="ctl00_Layout_lblContent">Questions must be addressed, such as, if the surviving minority stockholders decide not to resign, will the new owner of the shares be content to allow the surviving minority stockholders to run the business? Conflicts of interest are sure to result. The surviving minority stockholders will undoubtedly be required to continue operating the business alone. They are likely to feel that more of the profits should go to them in the form of salary increases for their additional efforts. Will the new majority stockholder be willing to do this?</span></p>
<h5>
<span id="ctl00_Layout_lblContent">The Absence of Wills and Trusts</span></h5>
<p><span id="ctl00_Layout_lblContent">If the deceased majority stockholder does not have a will or living trust, the personal representative must dispose of the personal property of the estate for cash. This cash is used to pay the creditors of the deceased and to pay the taxes and administration expenses. What is left is forwarded to the heirs or beneficiaries who are entitled to it under the intestate laws of the state.</span></p>
<p><span id="ctl00_Layout_lblContent">If cash or other property exists that is sufficient to pay the debts, taxes, and administration expenses, then with the consent of all the heirs, provided they are all adult, the personal representative can conserve the deceased majority stockholder’s stock. He or she can then deliver the stock to those who are to receive it according to the directives of any preplanning or a buy-sell agreement. Otherwise, the personal representative must liquidate the shares of stock.</span></p>
<p><span id="ctl00_Layout_lblContent">If the stock must be liquidated, the estate may or may not be able to get a fair price for it. A factor that hinders obtaining a fair price for the stock is that the personal representative is required to carry out the administration of the estate with promptness. Naturally, prospective buyers are aware of this. A forced sale does not leave the estate in a very good bargaining position.</span></p>
<p><span id="ctl00_Layout_lblContent">Also, suppose administration of the estate takes place during a seasonal slump of the business or during a general business depression. A forced sale under these distressing conditions could result in a considerable loss to the estate and to the heirs.</span></p>
<h5>
<span id="ctl00_Layout_lblContent">The Presence of Wills and Trusts</span></h5>
<p><span id="ctl00_Layout_lblContent">If the deceased majority stockholder leaves a valid will or living trust, he or she must specifically address the issue of his or her shares of stock. If the stock has not been bequeathed or placed in a trust, the stock is not automatically liquidated to pay creditors and other claims, except as a last resort. However, if these shares represent a majority of the deceased’s assets, some portion will probably have to be sold to raise money for paying the debts.</span></p>
<p><span id="ctl00_Layout_lblContent">If such a sale is necessary, the sale may involve disposing of a number of shares, which can change the balance of control in the close corporation. In this case, the shares could bring a fair price from the surviving minority stockholders, but only if the stockholders have the funds available for the purchase. Otherwise, the remaining shares in the estate are of little value.</span></p>
<p><span id="ctl00_Layout_lblContent">Of course, it is possible to pass on these majority shares in-tact. However, the recipients of the shares inherit control of the corporation. Unless they can take an operative role in managing the corporation’s business, the corporation and the surviving minority stockholders will likely see difficulty, frustration, and even disaster in their futures.</span></p>
<h5>
<span id="ctl00_Layout_lblContent">Issues for the Surviving Minority Stockholders</span></h5>
<p><span id="ctl00_Layout_lblContent">A majority stockholder is one who holds the majority of a stock in a corporation. In a close corporation, the controlling interest of the deceased majority stockholder passes into the hands of a new majority stockholder. This is facilitated by the personal representative of the estate, who conveys the stock of the deceased majority stockholder to the heirs or to someone who purchases it from the estate. Typically, if no advanced plans are made, the stock generally passes to an heir, who becomes the new majority stockholder. This can be the spouse of the deceased, who is often inexperienced and usually has another agenda. The heir can also be an adult child who is unable or unwilling to contribute to the work of the corporation.</span></p>
<p><span id="ctl00_Layout_lblContent">Regardless of the personal characteristics of the heir, he or she is now the majority stockholder in this situation and has a voice in future meetings. Even in light of inexperience, this new interest can dominate the board. We know that the Board of Directors directs the management and dividend policy of the corporation, but the entire future of the close corporation can be changed upon the arrival of a new majority stockholder.</span></p>
<p><span id="ctl00_Layout_lblContent">Typically, in the event of the death of a majority stockholder, the surviving minority stockholders, those who own the lesser number of shares, are left to carry the burden of the work of the corporation. One option is for the minority stockholders to form a new organization. However, in doing so, they would have to sell their stock to raise capital. Unfortunately, little or no market exists for minority holdings in a close corporation.</span></p>
<p><span id="ctl00_Layout_lblContent">At the same time, minority stockholders can be outvoted at meetings, so their jobs are in jeopardy. They could choose to resign, but if they decide to leave and begin business on their own, they would have the corporation to deal with as a competitor, and they would not have an established client base. Such a situation is a perfect example of how important preplanning is, which gives minority stockholders control of the business in the event of the death of a majority stockholder.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">The Death of a Minority Stockholder</span></h4>
<p><span id="ctl00_Layout_lblContent">From the perspective of the corporate business as a whole, the consequences of the death of a minority stockholder can be just as grim as the loss of a majority stockholder. Often, it is the minority stockholders who contribute a major part of the effort, while the majority stockholder makes the most of the capital contribution.</span></p>
<p><span id="ctl00_Layout_lblContent">Regardless, the death of the majority stockholder or the minority stockholder interrupts the close and personal relationship of the principals.</span></p>
<h5>
<span id="ctl00_Layout_lblContent">Issues for the Heir and the Estate of a Minority Stockholder</span></h5>
<p><span id="ctl00_Layout_lblContent">The shares of the deceased minority stockholder pass to the hands of the personal representative, who is required to sell the deceased’s shares of the stock in the process of administering the estate. From that point, the shares’ final disposition depends on the status of the estate and on the provisions of the deceased’s will, if any. (Typically in a close corporation, the greater number of participants own minority stock interest.)</span></p>
<p><span id="ctl00_Layout_lblContent">If no provisions have been made in the will for the disposition of the stock, the personal representative is in a tenuous position. While he or she must collect the assets of the estate, including the stock, the personal representative can also be surcharged for any losses that result to the estate; he or she can also be surcharged for not selling the stock at an “adequate” price, even though a very limited market exists for minority interest in a close corporation. These scenarios all emphasize the fact that delay in the administration of the estate can be costly for their heirs. Preplanning by way of an agreement to sell these holdings to the surviving stockholders for a satisfactory price can avoid delay and unnecessary expenses to the estate. The close corporation can continue with a minimum of interruption.</span></p>
<p><span id="ctl00_Layout_lblContent">Regardless of whether a will exists, the position of the personal representative differs greatly from his or her position in the situation of the majority stockholder. In the case of the majority stockholder, because a controlling interest exists in the close corporation, the personal representative typically possesses a marketable estate asset. This is not to say that the stock is easily marketable—remember, these shares are not publicly traded in over-the-counter exchanges. In the case of a deceased minority stockholder, the only real available market for the stock is in the surviving majority stockholders. Because they already control the corporation, the bargaining position of the estate of the deceased minority stockholder is not a good one.</span></p>
<p><span id="ctl00_Layout_lblContent">Under optimum circumstances, the personal representative can dispose of the minority interest at a reasonable price, which is acceptable to the probate court. This price must also be acceptable to the estate. Further, the stock must be disposed of at this acceptable price within the limited probate period.</span></p>
<p><span id="ctl00_Layout_lblContent">If the will or trust specifically bequeaths the shares of the minority stockholder to one or more beneficiaries, or if an agreement exists where the heirs accept the shares, and if funds are available to pay estate obligations, then the minority stock ownership will ultimately pass into the hands of the deceased’s family.</span></p>
<p><span id="ctl00_Layout_lblContent">The optimum situation produces an heir who is ready, capable, enthusiastic, and willing to accept the surviving majority stockholders as his or her business associates. However, if the new owner of the stock is an inactive stockholder, conflicts and trouble will ensue. As we know, optimum situations do not commonly occur.</span></p>
<p><span id="ctl00_Layout_lblContent">Again, the issues of new ownership arise. The surviving spouse, adult child, or other relative as the new minority stockholder often has an agenda of his or her own, or perhaps this person is simply not experienced in business. Perhaps he or she is not at all familiar with this particular business.</span></p>
<p><span id="ctl00_Layout_lblContent">Although the deceased minority stockholder probably earned a good living as a result of his or her position and efforts in the corporation, it will prove very difficult to convince the new stockholder that this was more a result of the effort than merely the perks of the position.</span></p>
<p><span id="ctl00_Layout_lblContent">Coming into a business under these circumstances, new stockholders often expect favorable and consistent income in the form of dividends on the stock. In reality, this is not always possible. In fact, any surplus of corporate earnings usually goes toward the further development of the corporate business.</span></p>
<p><span id="ctl00_Layout_lblContent">Conflicts invariably arise, many of which cannot be resolved. Ultimately, either the new minority stockholder will concede and sell the stock at less than an acceptable price, or the conflict will escalate. Unfortunately, lawsuits over mismanagement often result. These lawsuits only worsen the problems, causing significant expense and even further strife.</span></p>
<h5>
<span id="ctl00_Layout_lblContent">The Absence of Wills and Trusts—Minority Stockholder</span></h5>
<p><span id="ctl00_Layout_lblContent">First, if no will or living trust exists, the personal representative is required to dispose of the stock for cash unless all of the heirs, provided they are all adult and capable of consent, agree to accept the shares in lieu of liquidation. Also, the estate must have sufficient other property to pay all the debts and obligations of the deceased and his or her estate.</span></p>
<h5>
<span id="ctl00_Layout_lblContent">The Presence Of Wills And Trusts—Minority Stockholder</span></h5>
<p><span id="ctl00_Layout_lblContent">If the deceased stockholder leaves a will or living trust without specific provisions for disposing of his or her stock, then the situation is the same: in the absence of any other agreement by the beneficiaries to accept the stock certificates rather than cash, the personal representative must sell the stock. Of course, such an agreement cannot be transacted unless the estate has sufficient other property available for discharging all estate obligations.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">The Death of an Equal Stockholder</span></h4>
<p><span id="ctl00_Layout_lblContent">Many close corporations are small, often comprised of one, two, or a few individuals. In close corporations that have only two stockholders, each stockholder owns one-half of the shares of stock. Many of these corporations began as partnerships and were incorporated later as the business and the need for limited liability grew.</span></p>
<p><span id="ctl00_Layout_lblContent">These types of informal close corporations are often referred to as <strong>incorporated partnerships</strong>. In an incorporated partnership, the decisions, the work, and the profits are shared equally. Often, these stockholders consider themselves partners, even referring to one another as partners.</span></p>
<p><span id="ctl00_Layout_lblContent">When such a close corporation suffers the death of one of the equal stockholders, the surviving stockholder must carry on alone. For a time, the surviving stockholder has no one with whom to share the decision making process and other burdens. In such a situation, the personal representative holds the position of the deceased at stockholders’ and directors’ meetings.</span></p>
<p><span id="ctl00_Layout_lblContent">Remember that the personal representative represents principally the creditors and the heirs of the deceased stockholder. Therefore, his or her perspective of the objectives of the surviving equal stockholder is limited. In the end, the deceased stockholder’s position is held either by some purchaser of the deceased’s stock, if the personal representative is required to liquidate, or by a member of the deceased stockholder’s family.</span></p>
<p><span id="ctl00_Layout_lblContent">Regardless of who the new stockholder is, he or she is unlikely to be an acceptable “equal” to the surviving stockholder. An equal stockholder cannot possibly be replaced in terms of objectives and the harmony that united the partners and created a successful business. Unfortunately, in these situations, the conflicts that arise often lead to the ultimate liquidation of the corporation.</span></p>
<p><span id="ctl00_Layout_lblContent">Just like the majority stockholder and the minority stockholder, equal stockholders must preplan, because issues for the heirs and for the estate of the majority stockholder, problems with an absence of wills or trusts, and benefits from the presence of wills and trusts are similar to those of the deceased minority stockholder.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Issues for the Inactive Stockholder</span></h4>
<p><span id="ctl00_Layout_lblContent">Inactive stockholders receive benefits from their investment in the business from dividends on their stock and from the potential appreciation in value of this stock. Desiring the greatest possible return on their investments, inactive stockholders are in a position to demand that dividends are distributed instead of increasing the salaries of the active minority stockholders.</span></p>
<p><span id="ctl00_Layout_lblContent">Unfortunately, unless the majority stock passes into the hands of an experienced recipient such as one who is already active in the affairs of the corporation, or one who is a favorable associate, or one who is willing to assume this burden, then the heirs and the estate are likely to be better off with the cash value of promptly liquidated stock.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">16 - </span><span id="ctl00_Layout_lblChapterName">Liquidating the Corporation</span></h2>
<p><span id="ctl00_Layout_lblContent">In the worst case scenario, a suitable arrangement may not be found for disposing of a deceased stockholder’s interest in a close corporation without an insured buy-sell agreement. In this case, the only alternative is to liquidate the close corporation. The terms <strong>liquidation </strong>and <strong>dissolution </strong>are often confused when referring to the termination of a corporation. Liquidation is sometimes called “winding up,” which is the process of settling or winding up the corporation’s affairs; it is the orderly disposition of the corporation’s assets. Winding up includes discharging the corporation’s outstanding obligations and liabilities and distributing the remaining assets, if any, to the individual stockholders.</span></p>
<p><span id="ctl00_Layout_lblContent">Conversely, dissolution refers to the formal termination of the corporation’s existence. It is the official termination of the corporation’s existence and its extinction as an entity.</span></p>
<p><span id="ctl00_Layout_lblContent">When the winding up process is concluded, Articles of Dissolution must be filed. Because the corporation was initiated by an act of power by the state, the existence of the corporation cannot be terminated except by that same act of the power. Therefore, a certificate of dissolution is issued by the state in which it was chartered. At this point, the legal existence of the corporation ceases for all purposes.</span></p>
<p><span id="ctl00_Layout_lblContent">When a corporation finally dissolves, taxation occurs at the corporate level or at the stockholder level. For taxation purposes, the corporation or individual stockholders must recognize any gain or loss on any distributed property or funds. In terms of capital gain, the stockholder is treated as if the liquidation distributions were the proceeds from the actual sale of his or her stock. Further, the corporation is generally required to recognize a gain or a loss on a liquidating sale of its assets to third parties, even when those proceeds are made to the corporation’s stockholders.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">4.</span><span id="ctl00_Layout_lblSectionNumber">17 - </span><span id="ctl00_Layout_lblChapterName">Planning for the Continuance of the Corporation</span></h2>
<p><span id="ctl00_Layout_lblContent">Obviously, a close corporation needs some type of viable agreement to handle the disposition of a stockholder’s interest in the corporation in the event of the stockholder’s death. Having such a plan in effect reaps two great benefits:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">The business of the corporation can be continued without interruption.</span></li>
<li><span id="ctl00_Layout_lblContent">The heirs can be promptly and fairly provided for.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">In a close corporation, such an efficient and reliable plan can be accomplished only when the surviving stockholders acquire the deceased stockholder’s shares. While this objective can be accomplished in the most efficient possible way with an insured buy-sell agreement, the alternative of succession planning and its disadvantages is first discussed, followed by a thorough discussion of the close corporation buy-sell agreement.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">Succession Planning</span></h3>
<p><span id="ctl00_Layout_lblContent">Many close corporations arrange to transfer stock only by a first-offer arrangement. Typically, this provision is part of the incorporation certificate, although sometimes it is a separate agreement. Such a provision provides that no stock of the corporation will be transferred to a person who is not already a stockholder unless the stock is first offered for sale to the other stockholders or to the corporation at some predetermined price.</span></p>
<p><span id="ctl00_Layout_lblContent">The right of the other stockholders to have this first opportunity of buying a deceased stockholder’s shares is known as the <strong>right of first refusal</strong>, which was discussed in Chapter 3. During the stockholders’ lifetime, this provision is essential to govern the transfers of stock. It serves to prevent any shares of stock from passing into the hands of outsiders.</span></p>
<p><span id="ctl00_Layout_lblContent">In a close corporation, the first-offer arrangement merely provides that if the estate or the heirs decide to sell the stock, they must give the surviving stockholders or the corporation the first opportunity to purchase it. Of course, the heirs/surviving stockholders are free to retain the stock if they wish. Naturally, if the heirs inherit a majority interest in the corporation, they will probably decide to retain their interest. However, this arrangement does not provide for the surviving stockholders to actually purchase the stock.</span></p>
<p><span id="ctl00_Layout_lblContent">The stockholders in a close corporation typically take their profits of the corporation in the form of salaries. This seems only fair, because in most cases, the share of these profits is directly attributable to the personal services and skills performed by the stockholders themselves against the earnings on their invested capital. In the event of the death of a stockholder, the importance of this method of payment becomes clearer when salary payments are discontinued.</span></p>
<p><span id="ctl00_Layout_lblContent">Another alternative that some close corporations use for providing for the transfer of stock is that, in the event of the death of a stockholder, the surviving stockholders have the option to purchase the deceased’s shares at a predetermined price and within some specified time.</span></p>
<p><span id="ctl00_Layout_lblContent">Under optimum circumstances, the surviving stockholders decide to purchase the deceased’s stock at an agreed price. In the best of all situations, they would have the money available to pay for the stock. The result is that the surviving stockholders are able to gain the full and complete ownership and control of the close corporation. At the same time, the heirs and the estate receive payment in full and in cash immediately.</span></p>
<p><span id="ctl00_Layout_lblContent">However, if the surviving stockholders are unable to exercise their option because of lack of funds, then this provision obviously does not go far enough to provide for the lack of funding. In the most complex of situations, a majority stockholder’s estate, now holding the power to vote, could vote against the corporation’s resolution to buy the deceased’s interest. In this case, the corporation is effectively declining to exercise its option. As a result, the majority interest could be offered to outsiders.</span></p>
<p><span id="ctl00_Layout_lblContent">For this reason, a close corporation is a prime candidate for the preplanning benefits of the buy-sell agreement. Often, the board members, officers, and shareholders enter into a buy-sell agreement with each other at the time of incorporation to prevent the stock from getting into the hands of those outside the original group of shareholders.</span></p>
<p><span id="ctl00_Layout_lblContent">Additionally, every minority stockholder in a close corporation has the duty to see that his or her stock interest does not pass into the hands of an inactive member of his or her family. Preplanning and a buy-sell agreement can avoid these issues and can guarantee the amicable continuity of the close corporation. Such an agreement permits the majority stockholders to purchase the shares at a fair price at the minority shareholder’s death. Such an agreement could also permit the shares to be redeemed by the corporation.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">Buy-Sell Arrangements for the Close Corporation</span></h3>
<p><span id="ctl00_Layout_lblContent">The close corporation can arrange for the sale of the business interest of a deceased stockholder with a buy-sell agreement. A buy-sell agreement for a close corporation is a binding contract between a seller and a buyer. It is an agreement for the sale of the stock to a designated buyer at a predetermined price. Moreover, the buy-sell agreement is the most secure plan for circumventing the many disturbing problems that the death of a stockholder brings. The agreement is set up in advance, and it is an enforceable contract.</span></p>
<p><span id="ctl00_Layout_lblContent">A valid buy-sell agreement between stockholders is really the only viable plan to ensure the successful continuation of the business of a close corporation. It ensures that the surviving stockholders will receive the full and complete ownership and control of the business. At the same time, it ensures that the deceased stockholder’s family receives the full value of the stock. To take these benefits one step further, an insured buy-sell agreement ensures that the money required to fund the purchase is available when it is needed.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Types of Buy-Sell Agreements</span></h4>
<p><span id="ctl00_Layout_lblContent">In a close corporation, the stockholders have a choice of buy-sell arrangements. These are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>the Stock Redemption Agreement</strong>—The stock redemption agreement is also sometimes called an <strong>entity purchase agreement</strong>. This type of agreement binds both the stockholders and the corporation. In the event of the death of a stockholder, the corporation is bound to purchase the stock to the extent of its available surplus. The redemption agreement allows for corporate funds to be used to purchase the stock. These funds are not tax-deductible. Naturally, the remaining stockholders own a larger portion of the corporation. However, the cost basis of their stock does not increase.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the Cross-Purchase Agreement</strong>—In the event of the death of a stockholder, the cross-purchase agreement binds the surviving stockholders to purchase one another’s shares of stock.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">When using a cross-purchase arrangement, the individual stockholders enter into an agreement without involving the corporation. The surviving stockholders must purchase the stock from the deceased stockholder’s estate. Only a surviving stockholder’s own funds can be used for this purchase.</span></p>
<p><span id="ctl00_Layout_lblContent">The agreement can be structured so that the deceased’s estate must sell the interest in the business, leaving the surviving stockholders with the option of purchasing the interest of the deceased’s estate directly. The main advantage of a cross-purchase agreement is that the surviving stockholders receive an accelerated cost basis in that portion of the stock that is purchased.</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>the Trusteed Cross-Purchase Agreement</strong>—The trusteed cross-purchase agreement is another means of providing for the complete disposition of a deceased stockholder’s shares. Where the cross-purchase style of a buy-sell agreement is preferred but the number of stockholders makes issuing policies between the stockholders cumbersome, a third-party arrangement can be used to facilitate the arrangement.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">A trust must be established, or a non-stockholder individual can act as an “escrow agent” for the group of stockholders. All of the stockholders execute the cross-purchase agreement; the stockholders, in turn, transfer their shares of stock into the trust, or to the escrow agent, who serves as the third party.</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>the “Wait and See” Style of Buy-Sell Agreements</strong>—Often, the choice between an entity purchase and a cross-purchase style of agreement is difficult because of the changing circumstances for the individual or the corporation. The climate of tax reforms and revisions can also create doubt as to the best approach to use.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">An arrangement that solves this dilemma is the “wait and see” buy-sell agreement. In this type of agreement, the owners agree among themselves to sell their shares to each other or to the corporation. The buy-sell agreement contains all of the required provisions, with two exceptions:</span></p>
<ul>
<li>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span id="ctl00_Layout_lblContent">The purchaser is not determined until after the death of a stockholder.</span></li>
<li><span id="ctl00_Layout_lblContent">The amount of purchase is not determined until after the death of a stockholder.</span></li>
</ol>
</li>
</ul>
<h4>
<span id="ctl00_Layout_lblContent">Factors in Determining the Choice of Buy-Sell Agreement</span></h4>
<p><span id="ctl00_Layout_lblContent">Many factors must be considered before deciding which of the four styles of buy-sell agreements is most suitable for a close corporation. Some of these factors are</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>convenience</strong>—The cross-purchase plan requires that the stockholders buy policies on each other. For the close corporation that has only a few stockholders, the cross-purchase agreement is usually more advantageous and practical. For the close corporation that has more than three stockholders, the cross-purchase plan may not be manageable. For example, in a five-person close corporation, each stockholder must purchase four policies, one on each of the other stockholder’s lives. This requires the purchase of 20 policies, which would be impractical.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">If the cross-purchase arrangement is beneficial for other reasons, the trusteed plan should then be considered. The trusteed plan provides many of the advantages of the cross-purchase plan while simplifying the process of policy procurement. Using the same five-person example, the trustee or third-party escrow agent requires only the purchase of five policies. Should the trusteed plan not be agreeable, then it then makes sense to go with the entity stock redemption style of agreement.</span></p>
<p><span id="ctl00_Layout_lblContent">If the stockholders are uncertain or disagree about the type of agreement they should choose, then the “wait and see” style of buy-sell agreement may be appropriate.</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>adjustment to equity</strong>—Using the cross-purchase agreement, the cash value in the policy that each stockholder owns on the lives of the other stockholders is an equity that must be addressed when a stockholder dies. Unless other provisions are made, the estate of the deceased stockholder owns the life insurance policies on the surviving stockholders.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">These policies’ cash values are includable in the deceased stockholder’s estate, and the surviving stockholders, or the close corporation, must make provisions to purchase these policies for the amount of the cash value. With such an arrangement, a transfer-for-value exposure is not really a risk. (Transfer-for-value means if a person sells or transfers a policy to another, a “transfer-for-value” regulation (IRS Code) takes affect and changes the cost and/or tax free components of that policy. Exceptions are made for family members, partnerships and corporations in which the individual is an owner.)</span></p>
<p><span id="ctl00_Layout_lblContent">If the buy-sell price is more than the death proceeds that the surviving stockholders receive, and a large balance was to be paid over time, then a transfer-for-value exposure does become a risk. The estate can then elect to hold the policies until the balance is paid in full to protect the note obligation.</span></p>
<p><span id="ctl00_Layout_lblContent">Using an equity-stock redemption style of buy-sell agreement establishes the cash values of the policies as an asset of the close corporation. As an asset, each stockholder’s valuation increases to reflect the growing asset. Therefore, the purchase price of the deceased stockholder’s shares is higher than that in the cross-purchase style of buy-sell agreement.</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>use of policy cash values</strong>—Using an entity stock redemption style of buy-sell agreement creates a corporate asset that is equal to the cash value of the policies that the corporation owns. As such, these funds are available for business purposes if they are needed. However, at the same time, these funds are at risk to corporate creditors.</span></li>
</ul>
<h4>
<span id="ctl00_Layout_lblContent">Tax Consequences of the Buy-Sell Agreement</span></h4>
<p><span id="ctl00_Layout_lblContent">Buy-sell agreements can have significant tax consequences to the corporation as well as to the individual stockholders. Therefore, careful consideration must be given to the tax effects of these arrangements during their planning and implementation. This is especially true in situations where the primary objective of the buy-sell agreement is to provide for the valuation of the shares at the death of the stockholder. If executed correctly, a binding determination as to the value of this asset can be made for estate tax purposes.</span></p>
<p><span id="ctl00_Layout_lblContent">For transfer tax purposes (when property is transferred), the Internal Revenue Service provides that the basis of property acquired from the deceased stockholder is the property’s fair market value. The purchase price set forth in a buy-sell agreement is generally recognized as the fair market value, provided that</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">the buy-sell agreement is a bona fide business arrangement;</span></li>
<li><span id="ctl00_Layout_lblContent">the buy-sell agreement is not just a method of transferring a stockholder’s interest for less than fair market value;</span></li>
<li><span id="ctl00_Layout_lblContent">the terms of the agreement are comparable to similar agreements.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">In addition, the following provisions are required for the agreement to be binding for federal estate tax purposes:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">The deceased’s estate must sell its stock, and a surviving stockholder or the corporation must buy or have an option to buy the stock.</span></li>
<li><span id="ctl00_Layout_lblContent">The agreement must restrict the stockholders from transferring their shares during their lifetimes.</span></li>
<li><span id="ctl00_Layout_lblContent">The purchase price agreed upon must be reasonable at the time the agreement is executed.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">If the corporation sets aside funds each year to fund the buy-sell agreement, the accumulated earnings tax can be imposed. In some cases, a penalty tax can be imposed on unreasonably accumulated earnings against the close corporation. Further, when the appreciated assets of the corporation are used to redeem the deceased’s shares, the corporation may have to recognize a gain for the difference between the basis of the amounts distributed and their fair market value.</span></p>
<p><span id="ctl00_Layout_lblContent">Unlike the payments made under partnership buy-sell agreements, payments made under a close corporation buy-sell agreement generally do not result in income to the deceased, unless the sale occurs before death, and the estate receives the proceeds after death.</span></p>
<p><span id="ctl00_Layout_lblContent">Other tax considerations are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">whether the close corporation’s premium payments can be taxed to the stockholders as dividends;</span></li>
<li><span id="ctl00_Layout_lblContent">whether the close corporation’s payments in redeeming a deceased stockholder’s shares can be considered a dividend to the surviving stockholders or to the estate;</span></li>
<li><span id="ctl00_Layout_lblContent">whether the death benefit proceeds will affect the calculation of the corporate alternative minimum tax; or</span></li>
<li><span id="ctl00_Layout_lblContent">whether the surviving stockholders have a greater need to realize a “stepped-up” cost basis for purchasing the deceased stockholder’s shares through the cross-purchase style of buy-sell agreement.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">When deciding on the appropriate design of a buy-sell agreement, complex tax issues are involved. As a result, competent tax and legal counsel should be consulted.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Enforcing the Buy-Sell Agreement</span></h4>
<p><span id="ctl00_Layout_lblContent">Using a buy-sell agreement compels the performance of buying and selling. The contracted parties are required to proceed with the purchase and sale of the business interest when a buy-sell contract is signed, because these agreements are matters of contract law.</span></p>
<p><span id="ctl00_Layout_lblContent">Generally, the failure of one party to carry out his or her contractual obligations results in an award of monetary damages to the injured party. However, in the case of a buy-sell contract for the sale of close corporation stock, the courts take the position that monetary damages really do not remedy the situation satisfactorily. This is mainly because no open market exists for shares of stock. Therefore, the courts enforce the agreements.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Restrictions on Transfers of Stock</span></h4>
<p><span id="ctl00_Layout_lblContent">One of the main characteristics of property is its transferability. The owners of property have the right and the power to dispose of their property. Generally, within the limitations of the Articles of Incorporation, a feature of the close corporation is that ownership interest in the company can be freely transferred. For example, shares of stock are considered negotiable instruments, and these can be transferred in the same manner as other personal property.</span></p>
<p><span id="ctl00_Layout_lblContent">In closely held corporations, transferring shares of a corporation is frequently restricted, because the existing stockholders often want to maintain or limit ownership. An insured buy-sell agreement permits retaining the ownership of the corporation.</span></p>
<p><span id="ctl00_Layout_lblContent">Because stock in a close corporation is considered securities, or negotiable instruments, some restrictions do limit the transfer of the stock. Typically, the transfer of the securities of a corporation can be conducted under the following circumstances:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">The transfer must be for the mutual convenience and protection of the parties.</span></li>
<li><span id="ctl00_Layout_lblContent">The transfer must not be unreasonable.</span></li>
<li><span id="ctl00_Layout_lblContent">The stock must be acquired within the terms of any restrictions.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">After the transfer has been established, the new stockowner acquires all of the rights and security of the stock.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Financing the Buy-Sell Agreement</span></h4>
<p><span id="ctl00_Layout_lblContent">Although a buy-sell agreement established before the death of a stockholder is necessary to ensure the successful continuation of the close corporation, the agreement must also be properly financed. Such a plan could not be implemented if the funds to conduct the transaction are unavailable.</span></p>
<p><span id="ctl00_Layout_lblContent">Of course, if the close corporation and the surviving stockholders are very liquid, they may be able to produce the cash necessary to finalize the buy-sell agreement without using insurance to finance the buy-sell agreement. Their alternatives to an insured buy-sell agreement, none of which are very practical, are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span id="ctl00_Layout_lblContent"><strong>building up the purchase price in advance through savings</strong>—The plan is impractical because no one knows exactly when the funds will be required. It may be days, or months, or years. In addition, the accumulated earnings tax can become an issue.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>paying the purchase price in installments</strong>—This plan is impractical because it essentially mortgages the business and the futures of the corporation and the surviving stockholders.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>borrowing the purchase price at the time of death</strong>—This plan is impractical because the ability to borrow cannot be ensured beforehand. The issues of mortgaging the futures of the corporation and the surviving stockholders apply here.</span></li>
</ol>
<h4>
<span id="ctl00_Layout_lblContent">Benefits of the Insured Buy-Sell Agreement</span></h4>
<p><span id="ctl00_Layout_lblContent">Life insurance can be used to fund buy-sell agreements. The premiums are relatively inexpensive, considering that the intended continuity of the corporation may be at stake. Using a buy-sell agreement funded by life insurance allows the heirs of the deceased stockholder to receive cash in exchange for their stock. By funding the buy-sell agreement with life insurance, the buy-out and its method of funding are predetermined; the viability of the corporation is guaranteed.</span></p>
<p><span id="ctl00_Layout_lblContent">The immediate benefits of the insured buy-sell agreement are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">it removes any doubt about whether the surviving stockholders will be in a position to purchase the deceased stockholder’s interest;</span></li>
<li><span id="ctl00_Layout_lblContent">it provides the surviving stockholders with the most convenient and practical methods of obtaining the purchase money when it is required; and</span></li>
<li><span id="ctl00_Layout_lblContent">it guarantees a market for the sale of the stock and fixes the value of the stock for estate tax purposes.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">In addition, the insured buy-sell agreement serves three functions:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">In the event of death of one of the stockholders, it places the entire ownership and control of the close corporation in the hands of the surviving stockholders.</span></li>
<li><span id="ctl00_Layout_lblContent">It provides the deceased stockholder’s estate with the full value of his or her stock in full and immediately.</span></li>
<li><span id="ctl00_Layout_lblContent">It provides a source of capital for the “living” buy-sell provisions (ownership/interest) through use of policy cash values.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">The insured buy-sell agreement has many other benefits as well. Benefits exist for the surviving stockholders, the heirs, the estate, and for the stockholders during their lifetimes.</span></p>
<p><span id="ctl00_Layout_lblContent"><strong>The benefits to the surviving stockholders are</strong></span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>the close corporation’s future is better assured</strong>—The insured buy-sell agreement ensures the continuation of the corporation business without interruption. The plan affects the purchase of the deceased stockholder’s interest in the company immediately. Because the agreement has been set up previously, the price has been agreed upon, and the money for the purchase is available. The business remains sound.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the surviving stockholders avoid liquidation losses</strong>—The liquidation of a going business invariably results in substantial losses, which are avoided with the insured buy-sell agreement.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the surviving stockholders avoid business disruption </strong>in the form of a new stockholder.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent"><strong>The benefits to the heirs and to the estate are</strong></span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>the estate receives payment in full and in cash immediately</strong>—The insured buy-sell agreement immediately places the full amount of the sale price of the deceased stockholder’s interest in the hands of the personal representative. There is no bickering, bargaining, or delay.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the estate can be settled promptly and efficiently</strong>—Using a buy-sell agreement, the immediate cash allows the personal representative to promptly, efficiently, and economically administer the estate.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the surviving spouse is relieved of business worries </strong>in terms of future responsibilities for the corporation.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent"><strong>The benefits to the stockholders during their lifetimes are</strong></span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>the corporation is stabilized</strong>—With the stabilization of the business assured, the partners are at liberty to pursue the business of the corporation. Employees are assured of a more secure organization. The funds of the corporation are not drained.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>a savings medium is provided</strong>—The insured buy-sell agreement is essentially an advance installment method of purchasing a deceased stockholder’s interest. This is a savings program automatically completed. The policy contains a cash value, making it a convenient and effective savings program that is directly focused on a single objective.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the future of the corporation is bright</strong>—With a buy-sell agreement in place, each stockholder can predict what will happen in the event of the death of one of the other stockholders. The business will survive.</span></li>
</ul>
<h4>
<span id="ctl00_Layout_lblContent">Provisions of the Insured Buy-Sell Agreement</span></h4>
<p><span id="ctl00_Layout_lblContent">Although it is a relatively simple instrument, the buy-sell agreement should be drawn by a competent attorney, because the insured buy-sell agreement is the legal basis for ensuring that, upon the death of a participant in a close corporation, the surviving stockholders will succeed to the agreement’s full control and ownership. Moreover, the agreement provides that the estate of the deceased stockholder will receive the full value of his or her stock interest at once.</span></p>
<p><span id="ctl00_Layout_lblContent">The three main elements of the close corporation’s insured buy-sell agreement are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">the surviving stockholders bind themselves to purchase the deceased stockholders stock;</span></li>
<li><span id="ctl00_Layout_lblContent">life insurance policies are carried on the life of each stockholder to supply the purchase money for the deceased stockholder’s interest; and</span></li>
<li><span id="ctl00_Layout_lblContent">the personal representative of the deceased will transfer the deceased’s shares of stock to the surviving stockholders with the payment of the purchase price.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">Naturally, no two agreements for the purchase of a deceased stockholder’s shares of stock are exactly alike. However, the close corporation insured buy-sell agreement should include the following provisions:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">a commitment that the stockholders will not sell or otherwise dispose of their stock during their lifetimes without first offering it to the other stockholders or to the corporation in the case of a stock redemption agreement;</span></li>
<li><span id="ctl00_Layout_lblContent">a commitment that the surviving stockholders will buy and the deceased’s stockholder’s estate will sell and transfer the deceased’s stock interest to the surviving stockholders or to the corporation in the case of a stock redemption agreement;</span></li>
<li><span id="ctl00_Layout_lblContent">a commitment for the purchase price for the stock and the valuation method for determining the purchase price;</span></li>
<li><span id="ctl00_Layout_lblContent">a commitment to purchase and maintain life insurance policies in the agreed amount on the lives of the stockholders for financing the purchase. In the case of a stock redemption agreement, the corporation purchases and maintains the policies;</span></li>
<li><span id="ctl00_Layout_lblContent">a description of the life insurance policies;</span></li>
<li><span id="ctl00_Layout_lblContent">a provision for the ownership and control of the life insurance policies and the disposal of the policies, as well as the conditions of policy ownership transfers;</span></li>
<li><span id="ctl00_Layout_lblContent">a commitment for the time and manner of paying any balance of the purchase price exceeding the insurance proceeds and for the disposition of any insurance proceeds in excess of the purchase price.</span></li>
</ul>
<h4>
<span id="ctl00_Layout_lblContent">Contents of the Buy-Sell Agreement for a Close Corporation</span></h4>
<p><span id="ctl00_Layout_lblContent">The following illustrates the general structure of a buy-sell agreement. Naturally, no two agreements are exactly alike. However, all insured buy-sell agreements used for the purchase of a deceased’s stockholder’s interest in a close corporation should include</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>the parties to the agreement</strong>—The necessary parties are the stockholders. Often, a trustee whom the stockholders select is a party to the agreement as well. The trustee serves as an impartial third party. He or she holds the shares of stock and the insurance policies during the lifetimes of the stockholders. When a stockholder dies, the trustee supervises the buy-sell agreement transaction. However, the participation of a trustee is not required.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">If the buy-sell agreement is a stock redemption agreement, the corporation must also be a party to the agreement, because the corporation itself will acquire the shares of the deceased stockholder.</span></p>
<p><span id="ctl00_Layout_lblContent">In community property states, it is generally advised that the spouses of the stockholders be parties to the agreement.</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>the purpose of the agreement</strong>—The insured buy-sell agreement should contain a statement of its purpose and intent. It should</span>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span id="ctl00_Layout_lblContent">identify the parties as active stockholders;</span></li>
<li><span id="ctl00_Layout_lblContent">state that the transfer of stock to anyone other than the surviving stockholders disturbs the success, management, and control of the corporation;</span></li>
<li><span id="ctl00_Layout_lblContent">state that the parties want to avoid such an occurrence.</span></li>
</ol>
</li>
<li><span id="ctl00_Layout_lblContent"><strong>the “first-offer” commitment</strong>—The agreement should contain a provision stating that if any of the stockholders desire to dispose of their interest in the corporation, they must first offer the shares to the other stockholders.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the commitment to sell and buy</strong>—The agreement should clearly state that upon the death of a stockholder, his or her estate will sell and the surviving stockholders will buy all of the stock that the deceased owns at the time of his or her death. In the case of the stock redemption agreement, the stockholders commit their estates to sell the stock to the corporation, and the corporation agrees to purchase them from the estate.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the price to be paid and the valuation formula</strong>—Designating the purchase price to be paid for the business can be done in several ways, but it is always paid per share. The stockholders can select any valuation formula that is suitable to them, but the agreement must state the chosen method.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>financing the purchase with life insurance</strong>—The life insurance policies, which are part of the buy-sell agreement, should be recorded in the body of the agreement. Alternately, they can be appended to the agreement. The agreement should state that the insurance is intended to provide cash, which is to be applied toward the purchase price of the deceased stockholder’s shares of stock.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">The agreement should further state that the proceeds of the insurance when received by the deceased’s estate, whether directly as named beneficiary or indirectly from the surviving stockholders or the trustee, will be considered payment for the purchase price of the stock.</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>provisions for adding, substituting, or withdrawing policies</strong>—Because a stock purchase agreement is likely to remain in effect for many years, changes in the value of the corporation can occur during the time the buy-sell agreement is in force. Consequently, the amount of life insurance should also be changed.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">For example, if the value of the stock increases, the stockholders will naturally want to buy additional life insurance. If, on the other hand, the value of the stock decreases, the stockholders may want to discharge some of the insurance. The agreement should specify how all parties can add, substitute, or withdraw policies. Naturally, the record of any changes should be made part of the original agreement.</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>adjustments to the purchase price</strong>—The insured buy-sell agreement should contain provisions for any adjustments that may occur if the insurance proceeds and the purchase price differ. In some cases the amount of insurance proceeds can differ from the purchase price. Typically, the agreement should provide that if the purchase price is less than the insurance proceeds, the purchase price will be the amount of the insurance proceeds. So, the amount of insurance proceeds is essentially the purchase price.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">On the other hand, if the purchase price is more than the insurance proceeds, paying the balance can be handled in many ways. For example, if the balance is small, the stockholders should be required to pay it in cash when the stock is transferred. If the balance is larger, other arrangements must be made. For example, the surviving stockholders can pay the balance with interest-bearing notes, or the corporation can pay the balance using a stock redemption agreement made payable to the estate.</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>securing unpaid balances</strong>—Security for any unpaid balance of the purchase price must be provided for. For example, the personal representative of the deceased can retain some percentage of stock, perhaps up to 150 percent of the amount of each unpaid note. In this case, the personal representative transfers the stock held as collateral as each note is paid.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the payment of premiums</strong>—The buy-sell agreement should state who must pay the life insurance policy premiums. In most purchase arrangements, each stockholder obtains and owns the policies on the lives of the other stockholders, and each stockholder pays for the policies. The proceeds of each policy represent the portion of the insured’s shares, which the premium payer is obligated to purchase.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">In the case of the stock redemption agreement, the corporation pays the premiums; however, the corporation should not pay the policy premiums unless the stock redemption plan is used. When using a cross-purchase plan, the corporation can make the payments on behalf of the stockholders and charge them to the salary accounts of the individual stockholders. This ensures that the premiums are paid.</span></p>
<p><span id="ctl00_Layout_lblContent">If the stock holdings are equal, the premiums can be allocated by pooling and sharing them equally. If the ages of the stockholders are significantly different, then the pooling of premiums essentially requires the older stockholders to pay more than their fair portion.</span></p>
<p><span id="ctl00_Layout_lblContent">If each stockholder shares equally in the premium payments, he or she is entitled to equally share in the cash values of the policies. The problem for the older stockholders encountered in pooling is that the cash value credits do not correspond with the cash values in the policies on their own lives.</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>ownership of the insurance policies</strong>—The buy-sell agreement should designate who owns the right to exercise the benefits and privileges of each policy during the insured’s lifetime. For example, if a trustee is made a party to the agreement, the ownership benefits may be vested in the trustee. Otherwise, it is reasonable that the owner of each policy should receive the benefits of the policy.</span></li>
</ul>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">In the case of a stock redemption agreement, the corporation is the logical receiver of the benefits. Also, if exercising ownership rights is restricted in any way, these restrictions should be clearly identified in the agreement.</span></li>
</ul>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>disposition of policies on the lives of survivors</strong>—The cross-purchase agreement should contain provisions for disposing of the insurance policies on the lives of the surviving stockholders after the death of one of the stockholders. Typically, each insured is granted an option to take over the insurance on his or her life after the differences in cash values are adjusted. The buy-sell agreement must be revised for the remaining stockholders.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>provisions for amending, revoking, or terminating the agreement</strong>—The buy-sell agreement should permit the stockholders to amend, revoke, or terminate the agreement at any time. Such actions should be defined in writing. Events that initiate amending, revoking, or terminating the agreement are the dissolution or bankruptcy of the corporation.</span></li>
</ul>
<h4>
<span id="ctl00_Layout_lblContent">Valuation of the Stockholders’ Interest</span></h4>
<p><span id="ctl00_Layout_lblContent">The value of each stockholder’s interest in the close corporation must be established, and the price to be paid for his or her interest must be determined. The purchase price used in the agreement can be established using one of the following methods:</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>by a qualified appraiser</strong>—This method is referred to as the <strong>appraisal method</strong>. This method of valuation is sometimes sound, because at the time of the drafting of the agreement, the stockholders cannot possibly know the valuation of the stock at some unknown time in the future. Using an independent appraiser to determine the worth of the stock at the time of a stockholder’s death is referred to as the <strong>post-departure method</strong>.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">A distinct disadvantage of using the post-departure method is that getting the appraiser’s report is often delayed. Also, this method of valuation makes it difficult to determine in advance what the interest would be worth, if the stockholders need this information. The buy-sell agreement can specify the particular appraiser.</span></p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>by setting a fixed dollar price for the stock</strong>—This method of valuing the stock sets a price for the stock and is known as the <strong>set dollar method</strong>. As discussed in the previous chapter, the set dollar method is the greatest feature of preplanning. Using the set dollar method, the stockholders agree in advance that if one stockholder dies, the others will buy out his or her share on the basis of a predetermined price.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">The set dollar method is most effective when the primary worth of the business is the activity of the stockholders. It works best when the business has no substantial hard assets or much value in the inventory. This method is particularly good for most close corporation businesses, especially those in their first few years of business.</span></p>
<p><span id="ctl00_Layout_lblContent">Another perk of the set dollar method of valuation is that it combines simplicity with fairness: the buy-out price is fair, because it is known in advance, and all have agreed to it. Because the price is predetermined, appraisals and accountants are not necessary when a partner dies.</span></p>
<p><span id="ctl00_Layout_lblContent">The disadvantage of this method is that any fluctuations in the market value of the corporation’s assets are not reflected.</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>by setting a fixed dollar price, which is subject to an annual review</strong>—Using this method, any fluctuations in the market value of the corporation’s worth are reviewed annually to consider the changes.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>by determining the book value of the corporation on a specific date</strong>—Most commonly, the date of the death of a stockholder is used to determine the book value. The book value method is defined as the monetary value of the stock interest. It is probably the simplest method of valuing a stockholder’s interest.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>by determining the price with some formula</strong>—Using the formula method of valuation, the price can reflect any type of formula upon which the stockholders agree. For example, it may be a multiplier predicated on gross or net earnings.</span></li>
</ul>
<h4>
<span id="ctl00_Layout_lblContent">Beneficiary Arrangements</span></h4>
<p><span id="ctl00_Layout_lblContent">Naturally, the insured buy-sell agreement must state to whom the life insurance policies will be made payable in the event of the death of one of the stockholders. Naming a beneficiary in these situations usually follows one of four arrangements. These are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span id="ctl00_Layout_lblContent"><strong>the corporation as beneficiary</strong>—When using an entity stock redemption plan, the corporation itself is the purchaser of the deceased stockholder’s stock. Therefore, the corporation should be designated to receive the insurance proceeds.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>the trustee as beneficiary</strong>—If a cross-purchase plan is implemented, the stockholders can choose to have the plan administered by a trustee as an impartial third party. The best choice for the trustee is the corporation’s bank. In this case, the trustee should be the designated beneficiary of the life insurance policies.</span></li>
</ol>
<p><span id="ctl00_Layout_lblContent">Under these circumstances, the trustee is actually a party to the buy-sell agreement; this arrangement is referred to as a <strong>business insurance trust agreement</strong>. A business insurance trust agreement follows the cross-purchase agreement, tempered by the trust provisions. For example, the trust provisions should require</span></p>
<ul>
<li>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">the insurance policies to be made payable to the trustee.</span></li>
<li><span id="ctl00_Layout_lblContent">the insurance policies to be deposited with the trustee.</span></li>
<li><span id="ctl00_Layout_lblContent">the ownership rights of the policies to be granted to the trustee; however, the stockholders can retain these rights.</span></li>
<li><span id="ctl00_Layout_lblContent">the stockholders to endorse their stock certificates and deposit them with the trustee; however, the stockholders maintain their rights to receive all dividends payable on the stock and the right to vote their shares.</span></li>
<li><span id="ctl00_Layout_lblContent">the trustee’s job is to supervise and to administer the terms of the buy-sell agreement, in the event of the death of a stockholder. The trustee collects the life insurance proceeds and distributes them according to the agreement.</span></li>
<li><span id="ctl00_Layout_lblContent">If the insurance proceeds are not sufficient to cover the purchase price, as occurs in some situations, the trustee must obtain the notes, as required in the properly drafted buy-sell agreement. These notes obligate the surviving stockholders to make the payment of the purchase price directly to the deceased stockholder’s estate. The trustee delivers them the deceased’s personal representative with any required collateral. When the notes are paid, the personal representative returns the collateral to the surviving stockholders.</span></li>
<li><span id="ctl00_Layout_lblContent">Making a trustee part of the buy-sell agreement is recommended. It ensures that the purchase and sale of the deceased’s stock are handled efficiently.</span></li>
</ul>
</li>
</ul>
<p> </p>
<p> </p>
<ol>
<li value="3"><span id="ctl00_Layout_lblContent"><strong>the surviving stockholders as beneficiaries</strong>—If a business insurance trust agreement with a trustee is not implemented, the surviving stockholders should be made beneficiaries of the life insurance policies. This plan promptly places the funds for the purchase of the deceased’s stock with the surviving stockholders.</span></li>
</ol>
<p><span id="ctl00_Layout_lblContent">This arrangement renders some equity to the circumstances occurring at the death of a stockholder. For example, the surviving stockholders are bound to pay the agreed price for the deceased stockholder’s stock, and they hold the insurance proceeds until this transaction can be completed. On the other hand, the personal representative, holding the shares of stock, is bound to transfer the shares when the transaction is completed. Therefore, each side holds something the other wants, thereby balancing the power between the parties.</span></p>
<p><span id="ctl00_Layout_lblContent">The proceeds are included in figuring the cost basis of the shares of stock the survivors acquire. Further, the survivors have achieved a favorable income tax position in case they decide to sell these shares later.</span></p>
<p> </p>
<p> </p>
<ol>
<li value="4"><span id="ctl00_Layout_lblContent"><strong>the insured’s estate as beneficiary</strong>—Making the deceased’s estate beneficiary of the insurance proceeds does not permit a balance in the situation when a stockholder dies, because it favors the estate and not the surviving stockholders. In this situation, the personal administrator holds the stock and the funds to purchase the stock.</span></li>
</ol>
<p><span id="ctl00_Layout_lblContent">In the absences of such provisions in the buy-sell agreement, the insurance proceeds are not guaranteed to be used to credit the surviving stockholders with the funds needed to purchase the deceased’s shares of stock. In the worst of situations, the heirs could claim that they are entitled to receive these proceeds and the purchase price of the stock.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Tax Issues for the Buy-Sell Agreement for a Corporation</span></h4>
<p><span id="ctl00_Layout_lblContent">Using an insured buy-sell agreement, life insurance premiums are not a deductible business expense to the premium payer. However, when the corporation pays the insurance premiums and the premiums are charged to the stockholder’s salary accounts, the premiums can be deducted as <em>salary </em>for the corporation, although they are not deductible as <em>premiums</em>.</span></p>
<p><span id="ctl00_Layout_lblContent">For federal estate tax purposes, the basis of a deceased’s property is its fair market value at death or on the valuation date. The federal estate tax law specifically states the circumstances under which life insurance proceeds are considered taxable or non-taxable to the estate of the insured. If the insurance holds a non-taxable position, the estate is generally taxed on the value of the stock set forth in the buy-sell agreement, provided that the agreement meets the following criteria:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span id="ctl00_Layout_lblContent">The agreement must be part of a bona fide business arrangement.</span></li>
<li><span id="ctl00_Layout_lblContent">The agreement must not be a device to transfer the stock for less than full and adequate consideration in money.</span></li>
<li><span id="ctl00_Layout_lblContent">The terms of the agreement must be comparable to similar arrangements entered into by persons in other transactions.</span></li>
</ol>
<p><span id="ctl00_Layout_lblContent">On the other hand, if the insurance is arranged in a taxable way, the insurance proceeds must be included in the taxable estate of the deceased stockholder. The value of the stock equal to the value represented by the taxable insurance is excluded from tax.</span></p>
<p><span id="ctl00_Layout_lblContent">Generally, the value of the stock as agreed upon in the buy-sell agreement is its value for estate tax purposes, provided that the previously stated qualifications are met. However, additional tax issues may require the advice of competent tax and legal counsel.</span></p>
<h4>
<span id="ctl00_Layout_lblContent">Tax Issues for the Subchapter S Corporation</span></h4>
<p><span id="ctl00_Layout_lblContent">Our discussion to this point has addressed issues surrounding the arranging for the continuation of a close corporation. The methods of funding the buy-sell agreement as well as the tax issues involved have been related to the close corporation doing business as a <strong>C corporation </strong>for tax purposes.</span></p>
<p><span id="ctl00_Layout_lblContent">The <strong>subchapter S election </strong>of a close corporation, which is to be treated like a partnership for tax purposes, has some unique characteristics that must be addressed when arranging the buy-sell agreement.</span></p>
<p><span id="ctl00_Layout_lblContent">Under the subchapter S selection for Internal Revenue Service purposes, all stockholders income or losses are either <strong>active </strong>or <strong>passive</strong>. Those stockholders who participate in operating and managing the business are considered to have received<strong>active income</strong>. This is usually reported as <strong>W-2 wages</strong>. Those stockholders who do not participate in operating and managing the business are considered to have received <strong>passive income</strong>. This is usually reported as <strong>K-1 income</strong>.</span></p>
<p><span id="ctl00_Layout_lblContent">Each stockholder of a subchapter S corporation must include his or her share of the corporation’s profits, regardless of whether the amount was actually distributed to this stockholder. If the amount was not distributed to the stockholder, he or she will still have an income tax liability on that amount. The funds that were not distributed are kept by the corporation for business purposes and are referred to as <strong>undistributed taxable income</strong>, or <strong>retained earnings</strong>. These monies can be distributed in the future but will not be taxable as income, as they have already been taxed in the past.</span></p>
<p><span id="ctl00_Layout_lblContent">This creates a problem with a self-funded buy-sell agreement, because the funds that are set aside each year represent taxable income to the stockholders. The insured buy-sell agreement provides an advantage to the stockholders of a subchapter S corporation. Other tax issues unique to the subchapter S corporation should be discussed with competent tax and legal counsel.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">Buy-Sell Agreements for the Professional Corporation</span></h3>
<p><span id="ctl00_Layout_lblContent">In the past, a corporation could not practice a “profession,” because the canons of ethics by many professions such as law, medicine, and accounting prohibited it. However, when the Internal Revenue Service began to allow many tax-favored benefits for corporate employees, such as pension plans, profit sharing plans, group life and health plans, deferred compensation plans, and split dollar insurance plans, some professional groups formed non-corporate organizations. Through these organizations, professional groups could ethically practice their professions and be taxable as corporations, presuming they had a majority of corporate characteristics.</span></p>
<p><span id="ctl00_Layout_lblContent">Soon the states began to enact laws permitting only persons licensed to practice a particular profession to own interests in the corporation. For example, to maintain compliance with these statutes, if a stockholder lawyer dies, his or her estate must sell his or her stock interest only to a licensed lawyer or to the corporation.</span></p>
<p><span id="ctl00_Layout_lblContent">In 1969, the Internal Revenue Service conceded that the individual states should be permitted to determine the existence of a corporation. So, if a professional organization is recognized as a corporation by the state, it is a corporation for federal income tax purposes. Today, professional corporations are sanctioned in every state.</span></p>
<p><span id="ctl00_Layout_lblContent">So if a professional organization is formed as a corporation, a deceased stockholder’s stock must be sold to the surviving stockholders, to the corporation, or to members of the same profession. Naturally, most surviving stockholders would prefer to purchase the stock themselves or to have the corporation purchase it, rather than bring in a new stockholder.</span></p>
<p><span id="ctl00_Layout_lblContent">In the absence of a buy-sell agreement, many state statutes require that the price of a deceased stockholder’s shares in a corporation be determined by the book value method.</span></p>
<p><span id="ctl00_Layout_lblContent">Therefore, a satisfactory price for a deceased professional corporation stockholder must include satisfactory value for the tangible assets as well as the intangible assets like reputation, name, and good will.</span></p>
<p><span id="ctl00_Layout_lblContent">The value of these intangibles is best determined by the capitalization of earnings method, which demonstrates that the ongoing nature of a successful professional corporation does have real value. This method can be applied to the professional corporation’s average earnings, excluding professional salaries.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">5.</span><span id="ctl00_Layout_lblSectionNumber">1 - </span><span id="ctl00_Layout_lblChapterName">The Limited Liability Company</span></h2>
<p><span id="ctl00_Layout_lblContent">The popularity of the LLC has been steadily increasing since 1970, when Wyoming first established the limited liability company as a form of business entity. The LLC has now been adopted by statute in all 50 states and in the District of Columbia. Although all 50 states have adopted the LLC, the lack of uniformity between the various state statutes makes the LLC most attractive to those businesses that operate in one or two states.</span></p>
<p><span id="ctl00_Layout_lblContent">Before forming an LLC, as with sole proprietorships, partnerships, and corporations, certain factors should be considered. These factors include the tax implications, the benefits in establishing a family LLC as opposed to a family limited partnership, and the LLC’s effects on business planning. Full details on these issues are described in this chapter.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">5.</span><span id="ctl00_Layout_lblSectionNumber">2 - </span><span id="ctl00_Layout_lblChapterName">Integrating Corporate and Partnership Benefits</span></h2>
<p><span id="ctl00_Layout_lblContent">Forming an LLC is accomplished by drafting of articles of organization and filing them with the appropriate state agency. Most states require at least two members in the LLC, but some states will accept a one-member LLC. Owners of the business formed as an LLC are referred to as “members,” as opposed to stockholders of a corporation, or partners in a partnership.</span></p>
<p><span id="ctl00_Layout_lblContent">The limited liability company offers owners the limited liability of a corporation with the tax and management advantages of a partnership. The LLC is less restrictive than the S corporation and is not as complex. Instead of a corporate charter and bylaws of a corporation, the rules governing the LLC are established in an operating agreement.</span></p>
<p><span id="ctl00_Layout_lblContent">The limited liability company is a hybrid of the corporate and partnership business forms, providing the following advantages:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span id="ctl00_Layout_lblContent">The owners have no liability for business debts, which is an advantage enjoyed by corporations but not by partnerships.</span></li>
<li><span id="ctl00_Layout_lblContent">Income and expenses (profits and losses) are channeled to the individual owners, which is an advantage enjoyed by partnerships and S corporations, but not by C corporations.</span></li>
<li><span id="ctl00_Layout_lblContent">The number and types of owners have no restrictions; various classes of ownership are generally permitted, which is an advantage enjoyed by the C corporation, but not by the S corporation or partnerships.</span></li>
<li><span id="ctl00_Layout_lblContent">Profits and losses are channeled to the owners at different levels of participation ratios and distribution amounts as selected by the members, an advantage enjoyed by a C corporation in the limited sense of stock classes but not by the S corporation or partnerships.</span></li>
</ol>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">5.</span><span id="ctl00_Layout_lblSectionNumber">3 - </span><span id="ctl00_Layout_lblChapterName">Tax Issues of Selection</span></h2>
<p><span id="ctl00_Layout_lblContent">Before January 1, 1997, selecting taxation for the limited liability company was complex and uncertain. To be taxed as a partnership was the general rule, because six corporate characteristics had to be satisfied for the LLC to be taxed as a corporation. A limited liability company formed after December 31, 1996, will generally be taxed as a partnership if the company has two or more owners, or as a sole proprietorship if it has only one owner, unless it was elected to be taxed as a corporation. This election can now simply be made under the “check the box” regulations by filing form 8832.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">5.</span><span id="ctl00_Layout_lblSectionNumber">4 - </span><span id="ctl00_Layout_lblChapterName">Replacing the Family Limited Partnership</span></h2>
<p><span id="ctl00_Layout_lblContent">The family limited liability company has also grown in popularity as an alternative to the family limited partnership. The family limited partnership has been used for business and estate planning and continues to be used for that purpose. However, the family limited liability company is used as often or more often because of the liability protection benefit and the simplification of the taxation issue.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">5.</span><span id="ctl00_Layout_lblSectionNumber">5 - </span><span id="ctl00_Layout_lblChapterName">Effects on Business Planning Issues</span></h2>
<p><span id="ctl00_Layout_lblContent">The limited liability company can have members that are individuals, partnerships, or corporations. The tax status can be that of a sole proprietorship, partnership, or corporation. Therefore, additional information is necessary, along with competent tax and legal counsel, so that the business needs for life insurance can be properly presented and developed. The existence of the LLC does not change the nature of the business planning issues as discussed in this course.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">1 - </span><span id="ctl00_Layout_lblChapterName">Other Uses of Life Insurance in Business</span></h2>
<p><span id="ctl00_Layout_lblContent">In addition to the many uses of life insurance for purchasing a business interest for succession planning, other types of life insurance plans can meet the financial needs and provide economic stability for the business entity. These plans include key person insurance, split-dollar plans, Section 162 Executive Bonus plans, deferred compensation arrangements, and corporate-owned life insurance. This chapter describes each of these types of plans in detail.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">2 - </span><span id="ctl00_Layout_lblChapterName">Key Person Insurance</span></h2>
<p><span id="ctl00_Layout_lblContent">One of the most often used applications is that of providing various benefits to the <strong>key person </strong>of the business. A key person insurance plan can be easily set up to provide a<strong>death-benefit-only plan</strong>, or a <strong>non-qualified deferred compensation plan</strong>. A key person insurance plan can also provide a benefit to the business by insuring the value of the key person, or persons, as a human asset. The business must protect against the negative economic impact that the loss of such a person can have on the continued operations, customer relationships, and credit worthiness of the business.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">Who is a Key Person?</span></h3>
<p><span id="ctl00_Layout_lblContent">Generally, a key person is an employee whose death before retirement would have an adverse economic effect on the business. Such an adverse effect can be a loss of profits, the loss of credit standing, or the extra expense of hiring a capable replacement.</span></p>
<p><span id="ctl00_Layout_lblContent">The most objective test for determining exactly who a key employee is is the size of his or her salary. Naturally, a high salary is not the only criteria for determining a key employee, but it is typically an indication that this person is believed by management to be a valuable asset to the business.</span></p>
<p><span id="ctl00_Layout_lblContent">Another test for determining the key employee is his or her power over decision-making. If the person’s position permits him or her to make important managerial decisions or if this person exercises significant influence over the decision-making process, then this person may be considered invaluable to the success of the business. Such a person is a key employee.</span></p>
<p><span id="ctl00_Layout_lblContent">Other key employees are those who are directly accountable for performing management directives. Examples of such directives are in the areas of accounting, production, sales, or management. Sometimes a person who has customers or clients is considered a key person. This person’s position is invaluable because his or her death could result in the loss of a substantial portion of the business.</span></p>
<p><span id="ctl00_Layout_lblContent">An obvious key person is one whose presence represents a source of capital in the business. This may be direct or indirect, such as through the person’s standing in the community or his or her influence with lending institutions. Sometimes banks request a specific co-signer for business loans. Naturally, the death of this person would have detrimental effects on the sources of capital available to the business.</span></p>
<p><span id="ctl00_Layout_lblContent">Finally, a person can be considered a key person because of some unusual or unique talent he or she possesses. Regardless of this person’s job description, a key employee holds a unique and valuable position, and his or her talent would be not only difficult to replace but also costly to the company in the event of this person’s death.</span></p>
<p><span id="ctl00_Layout_lblContent">Conversely, key employees whose death would have a negative impact are typically not found in businesses where the company spreads its management responsibilities among many people or where a broad management-training program exists. However, a salary replacement plan may still be necessary. (A salary replacement plan is an insurance policy that allocates the proceeds to pay the salary of the replacement of the deceased.)</span></p>
<h3>
<span id="ctl00_Layout_lblContent">Benefits of a Key Person Arrangement</span></h3>
<p><span id="ctl00_Layout_lblContent">In a sole proprietorship, the key person is likely the owner. We have discussed in detail the need for a business owner to have contingency plans for his or her death. Even a sole proprietorship can be large enough to have one or more key people on board, and even though the sole proprietorship is owned by the proprietor, the proprietorship can have other valuable employees who have great knowledge and responsibility in the business. Likewise, a partnership can have key employees who are not partners.</span></p>
<p><span id="ctl00_Layout_lblContent">When such a key person dies, the effect can destroy the ability of the business to run efficiently, even if this person is not the owner. This person can bring great traits and qualities to the business, without which the entire business suffers. For example, increased expenses and smaller profit margins may result, or a reduction in production or sales. Other expenses are costs in locating, hiring, and training the person’s replacement, and these costs can reduce the profits of the business. Usually, during the time when the replacement is being sought, the work normally done by the missing key person is performed by those who are not prepared to handle the situation. They are often not as efficient or effective.</span></p>
<p><span id="ctl00_Layout_lblContent">Even when the replacement person is located, considerable money is likely involved with employment agencies or even relocation expenses. Further, when the replacement person is finally on the job, some time must likely pass before he or she is able to perform efficiently. The replacement’s learning curve may be lengthy.</span></p>
<p><span id="ctl00_Layout_lblContent">To avoid these problems, key employee life insurance is essential. When purchased by the business, the death proceeds of a key employee life insurance can provide a fund for off-setting a decrease in productivity and profits when a key person is no longer on the job.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">Insurable Interest</span></h3>
<p><span id="ctl00_Layout_lblContent">Whenever life insurance is purchased, there must be an <strong>insurable interest</strong>; insurable interest requires that a significant relationship exists between the insured and the person, business, or other third party involved in the transaction. The mere existence of an employer-employee relationship does not permit insurable interest. In addition, there must be reasonable grounds to expect some benefit or advantage from the continuance of the life of the insured. Otherwise, the arrangement can appear to be nothing more than a wager by which the benefiting party is directly interested in the early death of the insured.</span></p>
<p><span id="ctl00_Layout_lblContent">A business can purchase key employee life insurance on the life of someone who is active in the business and whose continued activities are reasonably expected to increase the future profits of the business. The business itself has an insurable interest because of the economic benefit it will derive from the continued life of the insured.</span></p>
<p><span id="ctl00_Layout_lblContent">A business owner can also purchase key employee life insurance. When a partnership has an insurable interest in a key person, each partner can also have an insurable interest in that key person, as measured in proportion to each partner’s ownership interest in the business. When a partner is the key person to be insured, the other partners may want to be owners and beneficiaries under the policy, rather than the partnership. This type of arrangement avoids the deceased partner’s estate sharing in the proceeds in proportion to its partnership interest.</span></p>
<p><span id="ctl00_Layout_lblContent">A recent example of life insurance that does not have a basis or reasonable grounds to establish insurable interest is the problems incurred by some large corporations in what was publicized as “Janitors Insurance.” In this instance, policies were purchased on a large number of employees, most of whom were not even aware of the existence of the policies, and the employer was the beneficiary. The employer could not substantiate an insurable interest. The death of any of these employees would not have negative economic consequences on the business.</span></p>
<p><span id="ctl00_Layout_lblContent">With key employee insurance, the beneficiary of the life insurance has reason to anticipate that some economic benefits result from the continuation of the insured’s life. The beneficiary also has reason to believe that these benefits are lost in the event of the insured’s death. In this respect, insurable interest falls under the category of <strong>pecuniary interest</strong>.</span></p>
<p><span id="ctl00_Layout_lblContent">It is held in all states that the requirement of an insurable interest exists only at the time that the life insurance policy is purchased. Insurable interest is not required at the death of a person; therefore, if a key person’s employment is terminated, the business continues to pay the premiums for the policy, and upon the insured’s subsequent death, the business receives the life insurance proceeds tax-free.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">Valuation of a Key Person</span></h3>
<p><span id="ctl00_Layout_lblContent">How much life insurance should a key person purchase? Many formulas can be used for valuing a key person, and no single formula is accepted as the best in every situation. Because the principal purpose of key person life insurance is to indemnify the business for the economic loss that it would suffer as a result of the death of the key person, the formula that best fits the structure of the business operation and the key person’s relationship to the success of the ongoing concern is preferable. The objective is to place the value of the key person in his or her relationship to the business, which can be a highly biased issue.</span></p>
<p><span id="ctl00_Layout_lblContent">Valuing a key person is much like valuing a business—it is more of an art than a science. One or more of the following formulas should provide a useful approach in determining the value of the key person:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>multiple of salary</strong>—Because salaries paid to the key person are generally an indicator of his or her value, a factor ranging from 3 to 10 times annual salary can be used. Often, the higher the salary, the higher the multiple that is used. However, in some circumstances the key person’s salary may be lower than the industry standard. Therefore, the position or contributions being made to the business must be considered to determine the multiple of salary that should be considered.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>business life value</strong>—The business must estimate the loss to annual earnings if the key person were to die. This annual loss is discounted by a selected interest rate for present value and is then multiplied by the number of years the key person would have worked until retirement. For example, consider a key person who was age 40 at death and the annual estimated loss was calculated to be $50,000. If the selected interest rate for present value factor were 10%, then the discounted annual loss to earnings would be $4,538 X 25 (years to retirement), or $113,450 as the value for the amount of life insurance.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>contribution to profits</strong>—This formula evaluates and then capitalizes the key person’s contribution to profits to determine the value. For example, the book value of a business is $1,000,000 and the expected rate of return on book value for that type of business is 9%. The expected rate of return would then be $90,000. However, the profits of the corporation are $200,000. The difference between the profits of $200,000 and the expected rate of return of $90,000 is $110,000. This is referred to as <strong>excess earnings</strong>, which reflect the success of the operations to that of the norm. If the key person is assumed to have contributed to 50% of the excess earnings success, then 50% of the $110,000, or $55,000, is factored into the capitalization formula to determine the key person value. Given these factors, the formula is:</span></li>
</ul>
<table align="center" border="0" cellpadding="0" width="300">
<tbody>
<tr>
<td>
<span id="ctl00_Layout_lblContent">$55,000</span></td>
<td>
<span id="ctl00_Layout_lblContent">(50% of $110,000)</span></td>
</tr>
<tr>
<td>
<span id="ctl00_Layout_lblContent"><u>X 8.33</u></span></td>
<td>
<span id="ctl00_Layout_lblContent">(capitalization factor)</span></td>
</tr>
<tr>
<td>
<span id="ctl00_Layout_lblContent">$458,150</span></td>
<td>
<span id="ctl00_Layout_lblContent">key person value</span></td>
</tr>
</tbody>
</table>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>discount of business</strong>. This formula is a simple discount to the value of the business as a result of the key person’s death. If the business value is $500,000, and the impact upon death of the key person is a discount of the value by 30%, then the value of the key person is $500,000 X 30%, or $150,000.</span></li>
</ul>
<h3>
<span id="ctl00_Layout_lblContent">Tax Issues of Key Person Insurance</span></h3>
<p><span id="ctl00_Layout_lblContent">In most circumstances, when a business secures key person insurance, the business entity generally pays the premiums and is the owner and beneficiary of the policy. Under this arrangement, no income tax deduction is permitted for paying the premiums. However, the premiums paid are also not treated as taxable income to the insured. In addition, any death proceeds of a key person insurance policy are tax-free, even if the key person is no longer employed with the business.</span></p>
<p><span id="ctl00_Layout_lblContent">In cases where an insured key employee terminates his or her relationship with the employer, he or she has various alternatives for disposing of the life insurance policy. Remember, the policy does not have to be surrendered. The business can continue to own the policy and to make the payments. However, care should be taken, because the insurable interest consideration could still apply. Each individual situation determines if the business can continue the policy without adverse consequences. The best course of action could be to surrender the policy to the insurance company for its cash surrender value. Then if the insured needs additional personal life insurance, the company can sell the policy to him or her.</span></p>
<p><span id="ctl00_Layout_lblContent">Whether the key person life insurance policy is surrendered or sold, the tax issues must be considered. Upon surrender or sale, if the amount the company receives exceeds its premium cost, this excess is taxable to the business as ordinary income in that year. If the policy has paid dividends, those dividends must be used to reduce the premiums paid to determine the policy’s cost basis.</span></p>
<p><span id="ctl00_Layout_lblContent">The federal estate tax law allows the death proceeds of a life insurance policy to be included in the gross estate of the insured under certain conditions. These conditions are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">if the proceeds are payable to or for the benefit of the insured’s estate; and</span></li>
<li><span id="ctl00_Layout_lblContent">if the insured at the time of his or her death possessed any incidents of ownership in the policy, regardless of the beneficiary.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">Generally, “incidents of ownership” in this sense refers to the right of the insured or his or her estate to the economic benefits of the policy. Therefore, included in this definition is the right to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, and to obtain from the insurer a loan against the surrender value of the policy.</span></p>
<p><span id="ctl00_Layout_lblContent">When a sole proprietorship or partnership is the owner and beneficiary of the policy and the insured possesses no incidents of ownership, no portion of the proceeds is included in the insured’s gross estate for federal estate tax purposes.</span></p>
<p><span id="ctl00_Layout_lblContent">When a partner is a key person, and because a partnership is considered a separate legal entity distinguishable from the individual partners, incidents of ownership in a life insurance policy possessed by the partnership do not apply to the individual partners. So, when a life insurance policy on the life of a partner is owned by and payable to the partnership, and all premium payments are paid out of partnership funds, the death proceeds are <em>not </em>included in the deceased partner’s gross estate. However, the proceeds the partnership receives are included as a partnership asset when valuing the insured partner’s interest in the partnership for federal estate tax purposes.</span></p>
<p><span id="ctl00_Layout_lblContent">The sale or transfer of a policy between a partnership and the partners generally does not create a “transfer-for-value” incident.</span></p>
<p><span id="ctl00_Layout_lblContent">The insured key employee may live to his or her normal retirement age. In such a case, the need for indemnity no longer exists. The business has various options for the disposition of a key employee policy:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">The business can continue to pay the insurance premiums and receive the proceeds tax-free upon the death of the former key person.</span></li>
<li><span id="ctl00_Layout_lblContent">The policy can be offered to the retiring key person at its present value. This person may need additional personal life insurance protection, or perhaps this person is uninsurable.</span></li>
<li><span id="ctl00_Layout_lblContent">The company can surrender the policy to the life insurance company for its cash surrender value.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">The cash values of the policy can be used to fund a non-qualified deferred compensation plan. Such a plan provides benefits to the key employee only in the event he or she lives to retirement.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">3 - </span><span id="ctl00_Layout_lblChapterName">The Split-Dollar Concept</span></h2>
<p><span id="ctl00_Layout_lblContent">We have discussed in detail how life insurance can be used in business to fund a buy-sell arrangement in the event of the death of a business owner, and we have presented the advantages of using life insurance to protect the business against the loss of a key person. Another use for life insurance in business is the split-dollar insurance plan.</span></p>
<p><span id="ctl00_Layout_lblContent">Split-dollar is an arrangement that allows a person who needs insurance protection to secure it at a cost that is less than it would be if this person had to purchase the insurance on his or her own. This concept refers to the division, or split, of the insurance proceeds. In most cases, the individual splits the premium payments with another individual or entity. These two parties share in the proceeds of the insurance based on the arrangement that they have entered into.</span></p>
<p><span id="ctl00_Layout_lblContent">In some arrangements, one of the parties can contribute the entire premium while the insured makes no contribution to the premium at all. This type of split-dollar arrangement is referred to as a <strong>non-contributory split-dollar plan</strong>, or in the case of an employer, an <strong>employer pay-all plan</strong>.</span></p>
<p><span id="ctl00_Layout_lblContent">A split-dollar plan incorporates the use of permanent life insurance, not term life insurance. Some potential situations where split-dollar plans could be used are the following:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">An employer offers split-dollar insurance as a fringe benefit for certain employees.</span></li>
<li><span id="ctl00_Layout_lblContent">A split-dollar arrangement provides a salary continuation plan to the surviving spouse of a key employee.</span></li>
<li><span id="ctl00_Layout_lblContent">A corporation establishes a split-dollar arrangement with a stockholder to provide personal insurance protection at a reasonable cost.</span></li>
<li><span id="ctl00_Layout_lblContent">A split-dollar plan funds a cross-purchase buy-sell arrangement.</span></li>
<li><span id="ctl00_Layout_lblContent">An owner of a sole proprietorship enters into a split-dollar arrangement with the key employee who is the designated purchaser of the proprietorship upon the death of the sole proprietor.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">Of course, the split-dollar insurance plan has other uses, too. Any company can limit split-dollar arrangements to executives or to any class of employees that it chooses.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">The Two Basic Styles of Split-Dollar Design</span></h3>
<p><span id="ctl00_Layout_lblContent">Split-dollar life insurance has two major styles:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span id="ctl00_Layout_lblContent"><strong>endorsement split-dollar design</strong>—Using this style of split-dollar life insurance arrangement, the employer applies for and owns the life insurance on the insured employee. Because the employer owns the policy, the employer is responsible for paying all premiums. The employer and the employee can enter into a split-dollar arrangement in which the employer allows the employee to split an agreed amount of the death benefit and to name a beneficiary to receive that stated amount as a death benefit. The employee’s rights are protected by an endorsement that is filed with the insurance company.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>collateral assignment split-dollar design</strong>—Using this style of split-dollar life insurance arrangement, the employee applies for and owns his or her own life insurance policy. The employee designates his or her own personal beneficiary to receive the death benefit proceeds. The employee is also responsible for paying all premiums. The employer and the employee can enter into a split-dollar arrangement in which the employer agrees to pay a stated amount of the premium in return for certain guarantees in the sharing of the life insurance proceeds. This arrangement protects the amount of premium the employer has committed to.</span></li>
</ol>
<h3>
<span id="ctl00_Layout_lblContent">ERISA Guidelines</span></h3>
<p><span id="ctl00_Layout_lblContent">Split-dollar insurance plans are generally considered welfare benefit plans under ERISA and are subject to the following requirements:</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent"><strong>reporting and disclosure</strong>—The type of split-dollar plan dictates the guidelines for compliance.</span>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ol>
<li><span id="ctl00_Layout_lblContent">A non-contributory, employer-pay-all endorsement style split-dollar plan for a select group of management or highly compensated employees is exempt from the reporting and disclosure requirements, except that the Secretary of Labor can request plan documents at any time, and the documents must be provided upon the request.</span></li>
<li><span id="ctl00_Layout_lblContent">A contributory collateral assignment style split-dollar plan having less than 100 participants is also exempt from the Reporting and Disclosure requirements, except that the Secretary of Labor can request plan documents at any time, and the documents must be provided upon the request. In addition, the employer must provide the employee with a summary plan description, which can be satisfied by providing a copy of the agreement and policy ledgers.</span></li>
</ol>
</li>
<li><span id="ctl00_Layout_lblContent"><strong>participation and vesting</strong>—Does not apply.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>funding</strong>—Does not apply.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>fiduciary responsibility</strong>—Can comply by naming the employer through one of its officers as the plan fiduciary. Requirements can be satisfied in a properly drafted split-dollar agreement.</span></li>
<li><span id="ctl00_Layout_lblContent"><strong>administration and enforcement</strong>—Requirements can be satisfied in a properly drafted split-dollar agreement.</span></li>
</ul>
<h3>
<span id="ctl00_Layout_lblContent">Tax Consequences of Split Dollar Plans</span></h3>
<p><span id="ctl00_Layout_lblContent">Under current regulations by the Internal Revenue Service, an employer can establish a split-dollar arrangement in one of two ways:</span></p>
<p> </p>
<p> </p>
<ol>
<li><span id="ctl00_Layout_lblContent"><strong>economic benefit regime</strong>—This is a straightforward method of providing the employee the advantage of death benefit protection at a cost that may be unavailable if the employee were to purchase insurance on his or her own. The economic benefit regime is used in conjunction with the endorsement style of split-dollar arrangement. The employer typically pays the entire premium and owns all of the policy cash value. The net amount of death benefit coverage provided to the employee each year constitutes a current economic benefit to that employee, and therefore, a calculated amount must be attributed as income for that year. The employee is responsible for paying taxes to the IRS on this attributed income. The current economic benefit is generally calculated by taking the amount of the net death benefit coverage provided that year to the Table 2001 rates as published. The per-thousand units of net death benefit protection multiplied by the rate-per-thousand in the 2001 Table produces the employee’s imputed income. For example, if the employee was age 45, his or her rate-per-thousand in the 2001 Table would be $1.53. If the employee had $100,000 of net death benefit protection in the year of calculation, his or her current economic benefit would be $1.53 X 100, or $153.00</span></li>
</ol>
<p><span id="ctl00_Layout_lblContent">The employer has no tax deduction for this attributed income amount.</span></p>
<p> </p>
<p> </p>
<ol>
<li value="2"><span id="ctl00_Layout_lblContent"><strong>loan regime</strong>—This method is generally used in conjunction with the collateral assignment style of split-dollar arrangement, or any arrangement in which the insured acquires an equity advantage without contributing to the premiums. The employer premiums are treated as loans to the employee, and the policy is collaterally assigned to the employer to secure the responsibility of the loan. Depending on the agreement, the employee either: (a) pays to the employer the market rate of interest on these loans; or ( receives as additional compensation an amount equal to the foregone interest.</span></li>
</ol>
<p><span id="ctl00_Layout_lblContent">These regulations apply to split-dollar insurance plans that were entered into after September 17, 2003. For split-dollar insurance plans that were entered into before September 18, 2003, a number of transition guidelines must be followed that relate to the number of revenue rulings issued by the Internal Revenue Service between 1964 and 2003. Some final pending regulations will clarify a few remaining issues.</span></p>
<p><span id="ctl00_Layout_lblContent">Premiums the employer pays for split-dollar life insurance plans are not tax deductible. The recovery of policy cash values to satisfy the loan under the collateral assignment arrangement is not taxable as income to the employer; neither are the death proceeds. Policy dividends are assumed to be paid to the employer and are usually not taxable until the policy is surrendered. The employer can use the dividends to reduce premiums or to purchase paid-up-additions to the policy.</span></p>
<h3>
<span id="ctl00_Layout_lblContent">The Use of Split-Dollar for Buy-Sell Arrangements</span></h3>
<p><span id="ctl00_Layout_lblContent">The split-dollar insurance plan can be used as a method for funding a buy-sell agreement. The style of split-dollar arrangements should be coordinated with the client’s objectives and the type of buy-sell agreement being considered.</span></p>
<p><span id="ctl00_Layout_lblContent">If the type of buy-sell agreement being considered is that of a stock redemption entity plan, a collateral assignment style of split-dollar would not be effective. However, an endorsement style of split-dollar could combine the repurchase of shares from the stockholder’s estate and provide for additional life insurance benefits for the personal needs of the stockholder.</span></p>
<p><span id="ctl00_Layout_lblContent">For example, consider a buy-sell agreement that values the stockholder’s shares of the business at $500,000. In addition, the stockholder needs personal life insurance in the amount of $400,000. Where the corporation may purchase $500,000 of life insurance on the stockholder to cover the buy-sell agreement alone, it would now purchase $900,000 on the stockholder and enter an endorsement style of split-dollar insurance for the amount of $400,000. The stockholder would have the current economic benefit on $400,000 attributed as income each year, but not on the $500,000 of coverage retained by the employer. Upon the death of the stockholder, the employer receives $500,000 of death benefit proceeds tax-free to satisfy the terms of the stock redemption entity buy-sell agreement, and the stockholder’s named beneficiary receives the $400,000 of death benefit proceeds tax free via the policy endorsement.</span></p>
<p><span id="ctl00_Layout_lblContent">If the type of buy-sell agreement being considered is that of a cross-purchase arrangement, both a collateral assignment style of split-dollar and an endorsement style of split-dollar could be effective. As in the previous example, assume that the value of the stockholder’s shares of the business is $500,000, but now we have two equal stockholders in the corporation.</span></p>
<p><span id="ctl00_Layout_lblContent">With a collateral assignment style of split-dollar insurance plan as the method of funding the agreement, the difference is that the stockholders are the owners and the beneficiaries of the policy on each other’s lives. Under this scenario, the loan regime applies to the owner of the policy, even though the insured is the other stockholder. The owner of the policy is responsible for the loan, not the insured or the beneficiary. Upon the death of one of the stockholders, the surviving stockholder receives the death benefit proceeds tax-free, settles the outstanding balance of the loan to the corporation, and uses the balance of the death benefit proceeds to satisfy the terms of the cross-purchase buy-sell agreement.</span></p>
<p><span id="ctl00_Layout_lblContent">With the endorsement style of split-dollar insurance plan as the method of funding the agreement, the employer applies for and owns a $500,000 policy on each of the stockholders. Each stockholder names the other stockholder as the beneficiary of the policy. Under this scenario, the economic benefit regime applies, and income is attributed to the stockholder on the life of the other individual insured stockholder.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">4 - </span><span id="ctl00_Layout_lblChapterName">The Section 162 Executive Bonus Plan</span></h2>
<p><span id="ctl00_Layout_lblContent">The Section 162 Executive Bonus plan is also referred to as an <strong>executive equity plan</strong>, <strong>executive bonus plan</strong>, or <strong>executive retirement bonus plan</strong>. The 162 executive bonus plan refers to section 162(a)(1) of the Internal Revenue Code, which authorizes a business deduction for salaries or other compensation as reasonable allowances for personal services actually performed.</span></p>
<p><span id="ctl00_Layout_lblContent">The executive bonus plan allows a corporation to provide needed life insurance protection for the selected employees on a tax-deductible basis for the employer. The employer has total discretion as to the selection of employees who participate in the plan, which may include both stockholder employees and non-stockholder employees.</span></p>
<p><span id="ctl00_Layout_lblContent">Under the executive bonus plan, the employee purchases and owns the permanent life insurance policy, and then enters into an agreement with the employer. The employer pays the entire premium on the policy to the insurance company, and attributes those payments to the employee as “other compensation” on the employee’s W-2 statement. This compensation is subject to Social Security (FICA) taxes as well as the Federal Unemployment (FUTA) tax.</span></p>
<p><span id="ctl00_Layout_lblContent">Because the employee owns the policy, and the employer has no rights or benefits in the policy, a written agreement is not required to be executed, as would be the case in a split-dollar life insurance plan,. However, it is always in the best interest of any planning activity to have some documentation to verify the intent of the activity taking place. Therefore, a resolution by the Board of Directors, or an agreement between the employer and employee would be beneficial, especially if the IRS attempts to treat the bonuses as non-deductible dividends to the stockholder employees.</span></p>
<p><span id="ctl00_Layout_lblContent">The executive bonus plan is only effective in conjunction with a C corporation because of the separate tax status that the C corporation enjoys as an independent entity. Neither the S corporation, partnership, or sole proprietorship can use the executive bonus plan, because they are pass-through entities and do not hold their own tax-bracket status.</span></p>
<p><span id="ctl00_Layout_lblContent">The advantages of the executive bonus plan are it</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">is easy to install;</span></li>
<li><span id="ctl00_Layout_lblContent">provides a tax deduction to the employer;</span></li>
<li><span id="ctl00_Layout_lblContent">can be selective in participation;</span></li>
<li><span id="ctl00_Layout_lblContent">provides death benefit protection and cash value accumulation to the employee;</span></li>
<li><span id="ctl00_Layout_lblContent">provides a life insurance policy to the employee that is unencumbered (the employer has no rights or benefits in the policy); and</span></li>
<li><span id="ctl00_Layout_lblContent">multiple policies can be paid with one business check from the employer.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">Executive bonus plans are most attractive when the employee-stockholder’s marginal tax bracket is lower than that of the corporation’s marginal tax bracket, because then a method is available in which the employee-stockholder can withdraw profits from the corporation in a reduced tax bracket environment.</span></p>
<p><span id="ctl00_Layout_lblContent">The executive bonus plan is also attractive to employee participants when they compare the tax liability due on the premium income against the cash value increase in that year. For example, if the premium imputed income was $2,000, and the employee participant was in the 25% marginal tax bracket, the tax liability is $500. If the policy cash value, which is owned by the employee participant, increased by $900 in that year, the increase in cash value more than offsets the tax liability on the attributable premium income.</span></p>
<p><span id="ctl00_Layout_lblContent">Because the employee participant owns the unencumbered policy and its cash value, the employee can access a portion of the cash value, tax-free, to pay for the income tax liability on the attributable premium income.</span></p>
<p><span id="ctl00_Layout_lblContent">As with life insurance proceeds in general, the death benefit proceeds of policies under an executive bonus plan are received by the named beneficiary income-tax free.</span></p>
<p> </p>
<p> </p>
<h2>
<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">5 - </span><span id="ctl00_Layout_lblChapterName">Deferred Compensation Arrangements</span></h2>
<p><span id="ctl00_Layout_lblContent"><strong>Deferred compensation arrangements </strong>allow an employer to defer income for selected management or highly compensated employees until after retirement. Under the deferred compensation arrangement, the employer has no current tax deductions to the agreement, and the employee has no current tax liability to the agreement. Employer tax deductions are postponed until the benefits are actually paid to the employee at some future time, generally at retirement. The employee’s tax liability is also postponed until the benefits are actually paid out to him or her at some future time.</span></p>
<p><span id="ctl00_Layout_lblContent">Under the typical deferred compensation arrangement, the employer promises to pay the selected employee a specified or unspecified amount for a fixed period of time or for life. The trigger to start these payments is usually stated in the agreement, and can be retirement or separation from service.</span></p>
<p><span id="ctl00_Layout_lblContent">The deferred compensation arrangement is a non-qualified plan, which means that the employer does not receive a tax deduction for the arrangement; the employer can be selective in who participates; and certain exemptions apply under the ERISA act. Two broad categories of a deferred compensation arrangement are (1) <strong>pure deferred compensation </strong>and (2) <strong>salary continuation </strong>plans. The fundamental difference between the two is that the pure deferred compensation plan generally encompasses an employee electing not to receive current income, whereas the salary continuation plan is provided by the employer as an additional benefit to all other current forms of compensation. The taxation of the two categories is similar.</span></p>
<p><span id="ctl00_Layout_lblContent">The general rules of the deferred compensation arrangement are</span></p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<p> </p>
<ul>
<li><span id="ctl00_Layout_lblContent">the participants in the plan have the status of a general unsecured creditor of the employer and that the plan merely constitutes a promise of payment in the future;</span></li>
<li><span id="ctl00_Layout_lblContent">a provision is included stating the intention of the parties and that the plan be unfunded for tax and ERISA purposes;</span></li>
<li><span id="ctl00_Layout_lblContent">a provision is included stating the time and method of paying the deferred compensation in relation to each event that triggers the distribution, such as retirement or death; and</span></li>
<li><span id="ctl00_Layout_lblContent">if the plan refers to an informal funding device or trust, additional requirements must be satisfied.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">The American Jobs Creation Act of 2004 imposed additional requirements to avoid<strong>constructive receipt </strong>issues. (<strong>Constructive receipt </strong>refers to any statement of ownership or allocation to the participant or in the participants name.) Internal Revenue Code Section 409A establishes six events in which the participant can receive a distribution of previously deferred compensation. These six events are</span></p>
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<li><span id="ctl00_Layout_lblContent">separation from service;</span></li>
<li><span id="ctl00_Layout_lblContent">date of disability;</span></li>
<li><span id="ctl00_Layout_lblContent">death;</span></li>
<li><span id="ctl00_Layout_lblContent">fixed time (or pursuant to a fixed schedule) as specified in the plan at the date of deferral;</span></li>
<li><span id="ctl00_Layout_lblContent">a change in the ownership of the employer and effective control of employer assets, as provided in the regulations; and</span></li>
<li><span id="ctl00_Layout_lblContent">the occurrence of an unforeseen emergency.</span></li>
</ul>
<h3>
<span id="ctl00_Layout_lblContent">Funded and Unfunded Arrangements</span></h3>
<p><span id="ctl00_Layout_lblContent">When a deferred compensation arrangement is established, it is either an <strong>unfunded arrangement </strong>or a <strong>funded arrangement</strong>. As a general rule, in an <strong>unfunded arrangement</strong>, the employee participant has no vested position in the assets that the employer may have set aside for the purpose of the arrangement. The employee participant will not have a constructive receipt. Further, the employee cannot be given any interest in any trust, annuity, escrowed account, or life insurance contract.</span></p>
<p><span id="ctl00_Layout_lblContent">A deferred compensation arrangement can be <strong>informally funded</strong>, for example, through the use of a <strong>rabbi trust</strong>, in which the employer sets aside assets so that the employee participants see that assets have been deposited for the future use of the deferred compensation arrangement. However, the employee participants can have no interest of ownership or vesting in the rabbi trust, and all assets must be the employer’s property, subject to the creditors of the corporation.</span></p>
<p><span id="ctl00_Layout_lblContent">An employer can informally fund a deferred compensation arrangement through the purchase of life insurance contracts or annuities without adverse tax consequences to the employee, as long as the employee has no interest in the contracts, and the contracts remain as unrestricted assets of the employer.</span></p>
<p><span id="ctl00_Layout_lblContent">If the deferred compensation arrangement grants the employee participants a vested interest, rights of ownership, or other forms of a secured interest, the plan becomes a<strong>formally funded </strong>arrangement for tax and ERISA requirement purposes. In some instances, employee participants are not always comfortable in an arrangement of promise without some form of security interest to protect against default on the promise or to protect against the loss of the employer’s assets to creditors. In these cases, using a <strong>secular trust </strong>is instituted, allowing the employee participants to have a vested interest in the assets of the trust. Although this gives the employee participants some protection against the assets held in the trust, the vested interest is a form of constructive receipt, which creates a tax liability to the employee participant.</span></p>
<p><span id="ctl00_Layout_lblContent">Special care must be given if one of the employee participants is a controlling stockholder in the corporation. Because the controlling stockholder can remove any restraints or restrictions, the IRS may challenge that there is constructive receipt—that any restrictions are a thin veil because the controlling stockholder can access the assets at any time. No barrier or firewall of restriction exists. The IRS has not made any advanced rulings in regard to this issue; therefore, it is difficult to eliminate these concerns. Numerous structure and tax issues must be recognized in establishing a deferred compensation arrangement, and competent tax and legal counsel should be sought.</span></p>
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<span id="ctl00_Layout_lblContent">Benefits of Deferred Compensation Arrangements for Key Personnel</span></h3>
<p><span id="ctl00_Layout_lblContent">The use of life insurance in a deferred compensation arrangement has a number of benefits for the employer and for the key personnel of the business. As an informally funded plan, the employee has no rights or interest in the asset. Therefore, the employee participant has no current tax liability. However, the cash value assets of the policy are clearly visible in the annual statements, allowing the employee participant to view the accumulation of funds that are being set aside for the purpose of the future distribution.</span></p>
<p><span id="ctl00_Layout_lblContent">The employer can structure the unfunded deferred compensation arrangement in such a way as to keep the focus of key personnel on the loss of future benefits should they consider leaving the firm. Of course, the provision in the agreement must be crafted so that it does not conflict with the regulations as set forth by the American Jobs Creation Act of 2004.</span></p>
<p><span id="ctl00_Layout_lblContent">In most cases, the key personnel of an employer are highly salaried and in the maximum income tax bracket margin. Deferring income to a future time when the employee participant is in a lower tax bracket margin can be an attractive benefit.</span></p>
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<span id="ctl00_Layout_lblContent">Salary Continuation Plans</span></h3>
<p><span id="ctl00_Layout_lblContent">A <strong>salary continuation plan </strong>is a form of deferred compensation arrangement in that it is a non-qualified plan with respect to tax issues and ERISA guidelines. The salary continuation plan is an agreement that the employer will continue paying a salary to the employee participant in the event of certain triggers. These triggers could be disability, death, etc. This arrangement is also referred to as a <strong>death benefit only </strong>plan. The language in the agreement must specifically deny the employee participant any rights or vested interest in the policy. Unless this language is in the agreement, the IRS can challenge constructive receipt or vested interest, which would then be taxable income.</span></p>
<p><span id="ctl00_Layout_lblContent">The primary difference between the salary continuation plan and the pure deferred compensation arrangement is that the salary continuation plan does not reduce compensation for services rendered by the employee participant. The salary continuation plan is an additional benefit to employees who have been selected by the employer to participate in the plan.</span></p>
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<span id="ctl00_Layout_lblContent">Insured vs. Uninsured Plans</span></h4>
<p><span id="ctl00_Layout_lblContent">The salary continuation plan can be unfunded or funded, just like the deferred compensation arrangement. The most common approach to the salary continuation plan is to purchase life insurance on the employee participants so that the employer has the funds to meet the obligations of the plan. The purchase of life insurance policies is considered an informally funded plan as long as the employee participants have no rights, vested interest, or claim to the assets. In addition, the cash value assets of the policies are considered to be the assets of the employer and are available for attachment by creditors of the employer.</span></p>
<p><span id="ctl00_Layout_lblContent">For the employer, using life insurance to fund the plan is attractive, because the premiums create a systematic savings plan to accumulate the funds for future pay-out of the terms of the agreement. The life insurance policies also provide cash value, which is treated as assets on the books of the employer. Although the employer cannot take a tax deduction for the premiums paid, the death benefit proceeds are received income-tax free. However, the death benefit proceeds can impact the corporate Alternative Minimum Tax. The employer’s payment to the deceased employee’s survivor are tax deductible to the employer in the years paid. If the trigger for the salary continuation plan is disability or retirement, the employer can access the cash value of the policy to fund the payments.</span></p>
<p><span id="ctl00_Layout_lblContent">If the salary continuation plan is not insured by a life insurance policy, the funds are not guaranteed to be available when needed. The employer would have to use assets that may be needed for the operations of the business, or the employer could be forced to borrow the money. Moreover, the employee participant may need the funds to be paid as stipulated in the agreement, and the lack of funds by the employer to satisfy the agreement could create a hardship for the employee participant.</span></p>
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<h2>
<span id="ctl00_Layout_lblChapterNumber">6.</span><span id="ctl00_Layout_lblSectionNumber">6 - </span><span id="ctl00_Layout_lblChapterName">Corporate Owned Life Insurance</span></h2>
<p><span id="ctl00_Layout_lblContent">Corporate Owned Life Insurance (COLI) policies were developed for corporations to informally fund or to recover the costs of non-qualified benefit plans. Non-qualified benefit plans provide income and benefits to key executives and to highly compensated employees beyond that which is available through the use of qualified plans.</span></p>
<p><span id="ctl00_Layout_lblContent">COLI products and plans generally provide</span></p>
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<li><span id="ctl00_Layout_lblContent">high early cash values ranging from 50% to 90% of premiums paid;</span></li>
<li><span id="ctl00_Layout_lblContent">guaranteed issue underwriting considerations;</span></li>
<li><span id="ctl00_Layout_lblContent">change of insured provisions;</span></li>
<li><span id="ctl00_Layout_lblContent">levelized commissions;</span></li>
<li><span id="ctl00_Layout_lblContent">flexibility in funding benefits from cash value and death benefit proceeds;</span></li>
<li><span id="ctl00_Layout_lblContent">enhanced limited pay or premium vanish features;</span></li>
<li><span id="ctl00_Layout_lblContent">contract guarantees on mortality and expense charges; and</span></li>
<li><span id="ctl00_Layout_lblContent">guarantees on credited interest rates.</span></li>
</ul>
<p><span id="ctl00_Layout_lblContent">Corporations use COLI policies to fund deferred compensation plans, salary continuation plans, key executive benefits, and other advanced planning concepts. Use of COLI plans with policy loans can require that existing plans be re-evaluated because of current restrictions on the corporate tax deduction for interest paid on policy loans</span></p>
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6. - AppendixThe following chart details some of the significant changes that Medicare will undergo, or has undergone, due to the Patient Protection and Affordable Care Act of 2010. 2010
PPACA provided an additional $250 million for the fight against Medicare fraud and abuse. The funds, to be used over ten years, were assigned to existing Health Care Fraud and Abuse Control funds. 2011
Free annual wellness visits and personalized prevention plan services were made available for Medicare beneficiaries.
Payments to Medicare Advantage companies were frozen at 2010 levels. Medicare provided a 10 percent bonus payment to primary care physicians and general surgeons. Part D provided a 50 percent discount on brand-name drugs in the donut hole. Created at “Innovation Center” at CMS to test new ideas for cost savings in Medicare. 2012
To enhance primary care services, physician payment reforms were enacted to encourage doctors to form or join “accountable care organizations” that coordinate care and improve patient health.
CMS begins tracking hospital readmission rates, which will penalize some hospitals and reward others. Medicare established an incentive program for hospitals to improve quality outcomes. 2013
Medicare will establish a pilot program in reference to “payment bundling” between hospitals, doctors, and other care providers to better coordinate beneficiary health care.
Medicare payroll tax will increase from the current 1.45 percent of a worker’s wages to 2.35 percent for individuals earning over $200,000, and married joint filers making over $250,000. An additional tax of 3.8 percent will be imposed on some investment income for the higher income group. The threshold for deducting medical expenses will increase from 7.5 percent of adjusted gross income to 10 percent of AGI. A 2.9 percent excise tax on medical devices will be imposed (to include “definitive devices,” such as wheelchairs and hearing aids). 2014
Medicare will begin to implement the recommendations of the Independent Payment Advisory Board (established by the act) in order to reduce the per capita growth in Medicare spending.
Medicare Advantage plans will be required to have medical loss ratios no lower than 85 percent. State health insurance exchanges will be established, as will mandates requiring individuals and employers to obtain health insurance. Health insurance companies will be required to pay a tax based on the size of their market share. 2015
Medicare begins a plan to pay physicians based on rewarding quality of care rather than volume of services.

5.1 - Medicare Part D
The goal of this chapter is to familiarize you with the Medicare Part D program, describe some of the problems of a rushed introduction and implementation of the program, introduce the basics and mechanics of the program, and discuss low-income options for certain individuals. Upon completion, you should be familiar with all of the following:
the hurried work and dedication of governmental entities to implement Part D;
the dedication and hard work of insurance people to market Part D in a short time;
the confusion that resulted for Medicare enrollees, their children, their professional advisors, and insurance agents in explaining Part D;
the basics and mechanics of the Part D program;
the variety of ways to qualify for assistance and “Extra Help” for low-income Medicare and Medicaid recipients;
high-income premium increases;
employer subsidies and programs for retaining retired workers on group health plans;
the complaint and appeals process for Part D; and
appropriate and correct marketing practices by both companies and producers.
5.2 - MMA 2003 Creates a New Prescription Drug ProgramMMA 2003 legislated a long-requested prescription drug solution for those on Medicare. The very name of the law—the Medicare Prescription Drug Improvement and Modernization Act of 2003—highlighted the fact that a completely new part of Medicare had been created: that of prescription drug coverage. The program was introduced to nearly 46 million beneficiaries and their families, physicians, and pharmacists, along with the American health care industry and the insurance industry.
Illustrating how quickly MMA 2003 was implemented are these facts:
On December 8, 2003, the bill became law.
A little over one year later, by January 21, 2005, CMS had established the final rules for implementing the law.
Four months later, in May of 2005, the Social Security Administration began sending notices to Medicare beneficiaries informing them that they may be eligible for a low-income subsidy to assist with Part D premiums and co-payments.
One month later, in June 2005, CMS sent notices to beneficiaries deemed eligible for the low-income subsidy, notifying them that they did not have to apply for the subsidy.
In the fall of 2005, Medicaid agencies sent notices to dual eligibles stating that their prescription drug coverage would be terminated on January 1, 2006, and that they would automatically be enrolled in a Medicare Part D plan. (The Medicare Part D low-income subsidy is also called Extra Help.)
Also, on October 15, 2005, CMS sent information to all Medicare beneficiaries describing the Part D program and identified the initial enrollment period of November 15, 2005, to May 15, 2006.
On January 1, 2006, the Part D benefit began.
Condensed to a list, all of this might seem fairly simple and straightforward, but the fact is, it took enormous effort and dedication on the part of hundreds of thousands of people to implement the program. For instance, in number 3 above, we see the work of CMS, DHHS, Medicaid, and other social workers moving forward rapidly. To accomplish numbers 4 and 5, CMS workers had to assist beneficiaries in transferring to Part D, because applying for the subsidy was unnecessary on the part of dual eligibles. Even though dual eligibles were automatically enrolled in the program, government workers were taxed to complete the job on time.
But even while the government was completing these tasks, another job had to begin, nearly simultaneously. That effort, one of marketing the Part D product, belonged to the insurance industry. This job, which was no small task, belonged to Medicare supplement producers and Medicare Advantage producers.
Included in MMA 2003 was a provision that Medicare (CMS) would open the program to prescription drug providers (PDPs)—private companies that would negotiate with pharmaceutical companies to include their drugs in the PDP company plan. Thus, Part D products were available only through the PDPs and not through Medicare itself.
With the exception of Extra Help and dual eligible government programs, consider that the Part D program is voluntary and requires marketing. This means that people can choose to be covered in one of two ways—by either voluntarily buying a stand-alone Part D plan or by enrolling in a Part C (Medicare Advantage) plan, which includes Part D in the plan. Stand-alone Part D programs were now to be sold by insurance agents, but more directly, by senior/retired market agents, Medicare supplement agents, or Medicare Advantage agents who had qualified for and received certification to sell Part D. Obviously, the Medicare Advantage programs could be sold only by those who were certified to sell MA.
The problems associated with this mass-marketing effort did not necessarily arise within the programs but were due to the confusion surrounding the large choice of programs available. This confusion was not limited to consumers. While potential enrollees and their friends, neighbors, children, and pharmacists tried to cope with all the new terminologies and choices, so too did those charged with selling the product. Training sessions were held for salespeople, and seminars, meetings, and workshops were held for consumers who were considering purchasing the program in one way or another.
In a letter to CMS in March of 2007, the American Academy of Actuaries pinpointed in one short paragraph what had happened. The letter stated:
Initial concerns that only a few sponsors would submit bids or that beneficiaries would only be able to select from a limited number of plans have proven to be unfounded. More than 1,400 prescription drug plans were offered in 2006 and most beneficiaries had more than 40 different plans to choose from. For 2007, the total number of plans increased to nearly 1,900, with most beneficiaries having 50 or more plan choices.
These numbers clearly show that Medicare enrollees were plagued with a barrage of mailings and media advertisements regarding the value of dozens of new prescription drug plans. Thus, potential buyers of Part D plans were obviously in a quandary about which was the best plan, and then, which was the best plan for their money. Part D agents, after studying a plan or several plans that they became qualified to offer, waded through the benefits of each, and were not allowed to discuss the merits or benefits of any competing plans. This left the client in the position of choosing from many different agents or mail order companies what they deemed the “best” plan for the “best” money. And of course, some people had no agent on whom to rely for advice. By 2010, the confusion surrounding the Part D program had still not subsided, and agents began to excuse themselves from assisting consumers who wanted stand-alone prescription drug plans.
So, naturally, the criticism of the program started and, as with Part C, the media showcased several examples of bad salesmanship. CMS was accused of creating a program that caused confusion and havoc with its constituency. Insurance agents and companies were accused of misleading the public and using inappropriate sales techniques. These negative outcomes notwithstanding, Part D became a substantial part of American health care. And when considering the millions of people covered, Part D was executed with comparatively few problems. Finally, the “noise” created by Part D implementation quieted, thanks to hundreds of thousands of hardworking individuals, both public and private.
5.3 - Introduction and Implementation of the Medicare Part D ProgramIn a 12-page bulletin issued January 21, 2005, CMS released its “Final Rules Implementing the New Medicare Law: A New Prescription Drug Benefit for All Medicare Beneficiaries, Improvements to Medicare Health Plans and Establishing Options for Retirees.” The first paragraph of the report summarizes the intent of the law established by MMA 2003. Its content can be used as a starting point for a discussion of the new Part D program:
The U.S. Department of Health and Human Services’ Centers for Medicare and Medicaid Services (CMS) today issued the final regulations implementing the new prescription drug benefit that will help people with Medicare pay for the drugs they need. This benefit begins in January 2006 and allows all Medicare beneficiaries to sign up for drug coverage through a prescription drug plan or Medicare health plan. The final regulations also provide new protections for retirees who currently receive drug coverage through their employers or unions, and they strengthen the Medicare Advantage program.
Two significant points in this paragraph serve as the basis for this chapter. The first point is “. . . drug coverage through a prescription drug plan or Medicare health plan.” This means the purchase of a stand-alone Part D plan or utilization of a Medicare Advantage plan. The second point, “ . . . new protections for retirees who currently receive drug coverage through their employers or unions,” refers to the concern that employers would drop retirees from their existing group health insurance because of escalating prescription drug costs. (We will address both of these points separately later in this chapter.)
A second paragraph in the “Final Rules” report summarizes the outlook for the new program:
With the enactment of the MMA, and the final rules issued today, Medicare looks more like the rest of the American health care delivery system by giving beneficiaries the option of new, subsidized drug coverage, as well as new support to keep their current retiree coverage secure.
And a final paragraph in the report describing the implementation of the Part D plan has significance to both Medicare Advantage plan representatives and Medicare supplement producers, stating:
The Medicare prescription drug benefit: The final rules describe the plan options that beneficiaries will have to obtain their outpatient drug coverage. Prescription drug plans and Medicare Advantage plans will be required to provide basic coverage, but may also offer additional plans with supplemental coverage.
Medicare supplement producers should not infer that this statement applies to Medicare supplement plans—the paragraph addresses prescription drug plans that providers offered to Medicare recipients beginning January 1, 2006. In other words, private companies—prescription drug providers or PDPs—offer the Part D plans, and payment for them will be through a Part D premium. At least one Medicare Advantage plan (per company) must have the Part D benefit built into its offerings.
MMA 2003 required (and allowed) PDPs to become available on a national as well as a regional basis. A PDP can call itself a national plan if it covers the 34 CMS PDP regions of the 50 states and DC, or if it covers 26 of the regions. Regional PDPs can serve fewer than 26 regions, and local plans can choose to operate in specific counties. National and regional PDP plans must have a network of contracting providers that have agreed to a specific reimbursement of the plan’s covered services; these plans must also provide uniform benefits within their service areas.
According to a “Medicare Fact Sheet” presented by the Henry J. Kaiser Family Foundation in June 2007:
Financing for Part D comes from beneficiary premium payments, state contributions, and general revenues from the Medicare program. The monthly premium paid by enrollees is set to cover 25.5 percent of the cost for standard drug coverage. CMS subsidizes the remaining 74.5 percent based on bids submitted to CMS by plans for their expected benefit payments. Plans can also receive additional risk-adjusted payments for high-cost enrollees and reinsurance payments for 80 percent of costs above the catastrophic threshold. A Part D plan’s total potential losses or profits are limited by risk-sharing arrangements with the federal government.
Even though the early years of Part D saw a large number of plans introduced (1,400 in 2006; 1,900 in 2007), the number of plans was reduced through consolidation and closing to a much more manageable 688 by 2013. However, the number of MAPD plans—MA plans that include Part D—grew to 2,703 as of 2013.
5.4 - The Mechanics of Medicare Part DAs written into MMA 2003, CMS must hold a single 45-day open enrollment period. (As you may recall, the annual enrollment period is the period—October 15 through December 7—when an enrollee can change plans or enroll in a plan.) Part D plans are known as either PDP or MAPD, depending on whether they’re stand-alone plans or are included as part of an MA plan. The new coverage takes effect on January 1 of the following year.
Also, the initial enrollment period for those turning 65 (aging in) tracks somewhat with Medicare enrollment rules in that the recipient can enroll in a Part D plan (stand-alone or MAPD) during the seven-month period that starts three months before the month he or she turns 65 and continues through the three months following the month he or she turns 65. The importance of these dates is that anyone who did not take advantage of the initial enrollment period will pay an additional premium surcharge: they will be assessed an additional 1 percent per month (cumulative) premium for each month they delayed enrollment, unless they could prove creditable coverage from an existing plan (for example, coming off an employer-sponsored group health insurance program). From that point on, the rules of the Part D plan are still in force for the remainder of the Part D program as it is written.
As an example, currently and in the future, anyone who delays Part D enrollment for four years (48 months) will see a 48 percent additional charge in his or her Part D premium. In short, late enrollees in the Part D program are surcharged, and the surcharge is cumulative from the time of enrollment and continues thereafter—the additional charge is added in perpetuity. The additional surcharge is based on the National Base Beneficiary Monthly Premium, established every year by CMS.5 (In 2012, this amount was $31.08; in 2013, it was $31.17.) How the Penalty Is AppliedAn example will help clarify how the Part D late enrollment penalty is applied. Let’s say that John became eligible for Medicare Part D on February 8, 2008, but he chose not to obtain Part D even though he had no other creditable coverage. At that time, John was in fairly good health, free of any chronic ailments that required regular prescription medication, so he thought the money he would otherwise have paid for prescription drug coverage could be better spent on other things.
In 2011, John was diagnosed with high blood pressure and high cholesterol and had to start taking prescription drugs every day to manage the effects of those conditions. When open enrollment came around at the end of 2011, John enrolled in a Medicare Part D prescription drug plan, and his Medicare Part D prescription drug coverage became effective on January 1, 2012. At that point, John had gone without Medicare Part D prescription drug coverage or any other creditable coverage for 46 full months, from March 2008 through December 2011.
The penalty for John’s late enrollment begins when he does enroll. For 2012, the penalty would be calculated as follows:
$31.08 (Medicare Part D base premium for 2012) x .01 = $.3108
$.3108 x 46 (months without Part D or other creditable coverage) = $14.2968
$14.2968 rounded to the nearest $.10 = $14.30
Each month in 2012, Robert had to pay a late enrollment penalty of $14.30 in addition to the premium for his Medicare Part D prescription drug plan.
In 2013, John’s penalty is recalculated, as it will be every year he remains in a Part D plan. In 2013, the Medicare Part D base monthly premium increased slightly to $31.17, but due to rounding, John’s late enrollment penalty will remain the same: $31.17 (Medicare Part D base premium for 2013) x .01 = $.3117.
$.3117 x 46 (months without Part D or other creditable coverage) = $14.3382
$14.3382 rounded to the nearest $.10 = $14.30
Each month in 2013, John will again pay a late enrollment penalty of $14.30 in addition to the premium for his Medicare Part D prescription drug plan. As the Medicare Part D base premium continues to adjust each year, so will the amount of the late enrollment penalty added to the premium John pays each month for his Medicare Part D prescription drug plan.
The premium surcharge is permanent; surcharged premiums will never be lowered. As a result, surcharged Part D premiums can become a financial hardship, especially when added to the inflationary increases in the price of the prescription drugs.
This concept, one of true insurance, is justifiable. The concept of delaying buying to save premium money is relative to any other life or health insurance product: the customer determines he or she is not going to pay premiums until coverage is absolutely necessary, and then buys it at the current (higher) rate. Age-rated insurance products use this concept, and Part D certainly uses the right strategy in relying on this fundamental principle.
In January 2007, DHHS issued a bulletin titled “Part D Special Enrollment Periods,” which stated, in part, the following:
In certain situations, people with Medicare may be eligible for a special enrollment period (SEP) to join a plan that provides Medicare prescription drug coverage, or switch to a different plan. A special enrollment period is a period of time when an individual can enroll in or switch plans outside of the October 15 through December 7 annual enrollment period.
Eligibility for SEPs can be determined from a list of 23 situations that may allow an enrollee to use a SEP. (Refer to the discussion of special enrollment periods in Chapter 4.)
5 The base premium is a statutorily defined percentage of the National Average Monthly Bid Amount, a weighted average of all the bids submitted by approved Medicare Part D prescription drug coverage plans.
5.5 - Foundation of Medicare Part D RulesTitle I of MMA 2003 describes the parameters of the Prescription Drug Act:
The MMA 2003 establishes a voluntary prescription drug benefit.
The benefit is for outpatient drug purchases.
The beneficiary must be enrolled in Part A and/or Part B of Medicare.
Coverage is provided through one of the following:private prescription drug plans, which offer drug-only coverage, and the beneficiaries remain in traditional Medicare for their Part A and Part B services; OR
Medicare Advantage plans, which offer both prescription drug and health care coverage (known as MAPD plans) and combine or integrate the Part D prescription drug coverages with the coverage for Part A and Part B services.
A new type of Medicare Advantage plan can be offered, which is a regional preferred provider organization (RPPO) plan. RPPOs must follow special rules:They must offer Medicare Part D Prescription Drug benefits.
They must place a cap on annual beneficiary out-of-pocket expenditures on Medicare cost sharing.
Every Medicare beneficiary must have access to at least two different Medicare Part D plans, one of which must be a PDP.
Both types of plans (PDP and MAPD) must offer a standard drug benefit but must have the flexibility to vary the drug benefit within actuarial equivalency parameters.
Assistance with premiums and cost sharing is provided to eligible low-income beneficiaries.
Covered Part D drugs are essentially the same drugs and biologicals that are approved for the Medicaid program. Drugs and biological products that are already paid by Medicare Part A or Part B are not included.
The drugs must be dispensed through a prescription and on an outpatient basis.
A member may be enrolled in only one Part D plan at a time.
The Part D Drug BenefitThe standard Part D plan is known as the basic standard plan. Medicare allows four variations of the basic standard plan, but these variations must all follow certain rules regarding construction of benefit packages and cost sharing. These variations are known as the:
alternative basic standard plan
alternative enhanced plan
alternative enhanced plan that offers supplemental prescription drug coverages
alternative enhanced plan that offers optional prescription drug coverage
One additional plan, called the fallback plan, can be offered in any region or in a local area of any region where a choice of at least two qualifying plans, one of which is a stand-alone PDP, does not exist. These plans can be offered by Medicare Advantage plans (MAPD) and have a wide variety of complexities and differences. Only the basic standard plan as it is designed as a stand-alone plan is discussed here, because it is the basis on which the other variations are built. The Basic Standard Part D PlanThe basic standard plan is the most commonly described plan and is the foundation of the Part D program, reflecting the minimum level of benefits that may be provided. It includes a formulary, which is the list of the drugs the plan covers. Formularies include both generic and brand-name drugs and provide for the most commonly prescribed drugs. Following are the principle aspects of the basic stand-alone plan:
Premiums for Part D are paid monthly and vary by plan and by provider. Basic Part D premiums were originally set at an anticipated benchmark of $37 per month, but in actuality, the prescription drug providers obtained lower premiums by bidding for the first year. (Premiums, however, are expected to rise each year as the program moves into maturity.) In 2013, the Part D plan premium averaged about $30 per month.
The basic Part D plan includes an annual deductible—the amount out of pocket the insured must initially pay for his or her drugs. The basic plan annual deductible in 2013 was $325.
Basic Part D plans include coinsurance provisions—the amount the insured pays for his or her prescription medication after the annual deductible is met. This coinsurance amount is 25 percent, payable by the insured up to a specified limit ($2,970 in 2013). Therefore, for expenses above the deductible and up to the specified limit, the Part D enrollee pays 25 percent; the plan picks up the balance.
The next level of expenses ($3,697.50 as of 2013) is known as the “donut hole” or “coverage gap.” Part D does not completely cover these expenses but does provide for discounts. While in the donut hole, the beneficiary pays 47.5 percent of the cost out of pocket for brand-name drugs and 79 percent for generic drugs. Coverage at this level continues until an enrollee has paid a full out-of-pocket cost of $4,750 (as of 2013). (The full out-of-pocket expense the enrollee is responsible for is also called TrOOP, or true out-of-pocket costs. TrOOP costs include the initial deductible, the coinsurance amounts, and any costs the enrollee paid while in the donut hole.) Though the enrollee pays a discounted price for drugs while he or she is in the donut hole, the full retail price of the drugs counts toward his or her out-of-pocket costs.
Once the total of an enrollee’s prescription drug costs reach a specified level (known as the catastrophic level), the plan will again pick up the bulk of expenses. The catastrophic level in 2013 was $6,667.50. (This amount is also expected to rise each year.) At this point, the beneficiary pays 5 percent coinsurance, and Part D pays 95 percent, OR the beneficiary pays a $2.60 or $6.60 co-pay, depending on the type of drug. So, at the catastrophic level, Medicare Part D essentially covers the remainder of the annual drug costs at 95 percent or better.The following table illustrates Part D expenses for beneficiaries in 2013: Standard Part D Plan (as of 2013) Prescription Drug Expense Payment Costs to Enrollee First $325 Enrollee pays 100 percent. $325 $325 to $2,970 Enrollee pays 25 percent; Part D pays 75 percent. $661.25 $2,970 to $6,667.50 Enrollee is in the donut hole and pays 47.5 percent for brand-name drugs and 79 percent for generic drugs. $3,763.75 At this point, total drug costs have reached $6,667.50, and the enrollee has paid $4,750 of TrOOP (true out-of-pocket costs). Above $6,667.50 Enrollee pays a nominal amount, or Part D picks up approximately 95 percent. Co-pay of $2.60 or $6.60 (or 5 percent) Changes to the Donut HoleOne of the goals of the 2010 health care reform law is to eventually close the Medicare Part D donut hole. To begin, PPACA provided for a one-time, tax-free rebate of $250 for Part D enrollees who reached the coverage gap in 2010 (and were not receiving Extra Help, explained below). Next, Part D enrollees who reach the donut hole are given a discount on their drugs while they are in the hole (a 52.5 percent discount on brand-name prescription drugs and a 21 percent discount for generic drugs, as of 2013). Again, though the enrollee pays a discounted price, the full retail price of the drugs counts toward the TrOOP costs, which will have the effect of moving the enrollee through the donut hole more quickly. Then, every year thereafter, the donut hole will be reduced, until the year 2020, at which point Part D will cover 75 percent of the cost of an enrollee’s prescription drugs. The enrollee will be responsible for a deductible and then only the remaining 25 percent of the cost of the drugs. Medicare and Medicaid Coordination—Dual EligiblesAs we’ve learned, a person who is eligible for both Medicare and Medicaid coverage is known as a dual eligible. For dual eligibles, Medicare coverage is primary, with all available benefits being used before Medicaid begins. Medicaid may also pay for items that Medicare does not cover, but coverage is based on showing financial need. States are rigorous in conducting their searches for assets and income. Medicare Part D and Low-Income Subsidy—Extra HelpOnce an individual is a dual eligible, prescription drug benefits are covered under the Medicare Part D program. Medicare automatically enrolls dual eligible individuals in a Medicare Part D plan.
Dual eligible individuals automatically qualify for the Medicare Part D low-income subsidy (Extra Help). The low-income subsidy pays all or part of the individual’s monthly premium for the Medicare Part D plan. Plans are available that the enrollee can join and pay no premium, and still others in which the enrollee would have to pay a portion of the premium. If the individual is enrolled in a Part D plan with a monthly premium less than the regional benchmark set by Medicare, his or her monthly premium is paid in full by Extra Help.
A dual eligible individual has no annual deductible; he or she is covered for prescription drugs, even through the Medicare Part D coverage donut hole.
In addition to Extra Help, there is the Limited Income Newly Eligible Transition (NET) Program. This CMS program provides Part D coverage for all low-income subsidy (LIS) beneficiaries with an immediate need who are not already enrolled in a Part D plan, and for full benefit dual eligibles (Medicare and Medicaid) with uncovered months (i.e., months without Part D coverage) in the past. The plan can be accessed by auto-enrolling with CMS, by filling a prescription at the point of sale, or by submitting a receipt for prescriptions already paid for out of pocket during eligible periods. The enrollment is for the current month and the next month, and provides an automatic enrollment in a standard Part D plan two months into the future. Assistance for Low-Income Beneficiaries—Medicare Savings ProgramsIn addition to these Extra Help programs are Medicare savings programs (MSPs). Many people do not enroll in Part B at the required eligibility date because they cannot afford the monthly premium. For those with incomes below 135 percent of the federal poverty levels, and with few resources, MSPs, which are operated by state Medicaid programs, pay the Part B premium. In addition, for those with incomes below 100 percent of poverty levels, an MSP called the Qualified Medicare Beneficiary Program will pay other Medicare cost-sharing expenses.
If an individual has a low income and limited resources, the state may pay his or her Medicare costs, including premiums, deductibles, and coinsurance. Each state has several programs that are part of the Medicaid savings programs that will pay some of the costs of Medicare.
Combined, the programs function under the common name of Medicare savings programs. The programs have similar names but offer different benefits. They also have slightly different qualifications. A person’s income and resources (if any) determine which program they can apply for.
Medicare savings programs are described by several names. As noted in Chapter 3, these include:
Qualified Medicare Beneficiary (QMB)
Specified Low-Income Medicare Beneficiary (SLMB)
Qualifying Individual (QI)
Qualified Disabled and Working Individual (QDWI)
In addition to all of these names, some provisions of MMA 2003 introduced special needs plans (commonly known as SNPs) to address the issues of special populations—the frail elderly, dual eligibles, and certain disease-specific populations. SNPs can limit their membership to only those defined populations and offer a combination of medical and Part D benefits. In addition, some of the Extra Help provisions of the programs cited previously can be included in SNPs.
MIPPA 2008 eased qualification requirements for Medicare savings programs and provided funding to Social Security and SHIP offices to train employees to better educate and assist beneficiaries in obtaining these low-income plans. In addition, MIPPA 2008 further defined SNPs as being reserved for those who
need an institutional level of care;
are dual eligible; and
have a severe or disabling chronic condition and have in place an evidence-based model of care (i.e., a care management program).
5.6 - Other Provisions Implemented with MMA 2003In addition to introducing a prescription drug benefit and making all of the changes to Medicare Part C, MMA 2003 set forth other changes. Chief among them was adjusting certain Medicare payments for higher income earners and providing incentives for employers to keep their older (Medicare-eligible) employees and retirees in their group health plans. Part B Premium Increases for High-Income EarnersMedicare Part B premium increases for higher income beneficiaries were included in MMA 2003. This process is known as means testing (income-related) and went into effect in 2007. The law provides for higher premium payments for Medicare Part B coverage and relates to the 25 percent payment that beneficiaries pay for Part B. Under the law, Part B monthly premiums are now tied to income levels, and Part D deductibles, coinsurance, and donut hole amounts will follow the inflationary trends built into Part D.
Beneficiaries who make more than specified amounts pay a greater monthly Part B premium. These threshold amounts are currently set at $85,000 for single filers and $170,000 for joint filers. The following shows monthly Part B premiums for 2013, based on the beneficiary’s modified adjusted gross income level: Modified Adjusted Gross Income Level Adjusted Amount (to be added to the monthly Part B premium) Total Monthly Premium Single filers: $85,000 and less Joint filers: $170,000 and less $0 $104.90 (standard premium) Single filers: Between $85,001 and $107,000 Joint filers: Between $170,001 and $214,000 $42.00 $146.90 Single filers: Between $107,001 and $160,000 Joint filers: Between $214,001 and $320,000 $104.90 $209.80 Single filers: Between $160,001 and $214,000 Joint filers: Between $320,001 and $428,000 $167.80 $272.70 Single filers: Above $214,00 Joint filers: Above $428,000 $230.80 $335.70 These amounts are subject to change every year. Beneficiaries can appeal their premium charge with Social Security if their family situation changes or their income declines. Part D Premium Increases for High EarnersBeginning in 2011, higher income Medicare beneficiaries who pay the income-related Part B premium will also pay an additional income-related Part D premium. This is known as a monthly adjustment amount. The monthly adjustment amount is not related to the premium of the plan in which such beneficiaries are enrolled but is based on a calculation determined by CMS. Thus, a single individual with a modified adjusted gross income of $86,000 will have a Part D monthly adjustment amount of $11.60 withheld from his or her Social Security check regardless of the Part D plan’s premium.
The monthly adjustment amount will automatically be deducted from the recipient’s monthly Social Security retirement check. Beneficiaries who pay the Part D monthly adjustment amount will continue to pay their regular Part D premium to the drug plan in which they enroll. Part D Income-Related Premium Adjustment Modified Adjusted Gross Income Level Income Related Monthly Adjustment Amount
(as of 2013) Single filers: $85,000 and less Joint filers: $170,000 and less $0 Single filers: Between $85,001 and $107,000 Joint filers: Between $170,001 and $214,000 $11.60 Single filers: Between $107,001 and $160,000 Joint filers: Between $214,001 and $320,000 $29.90 Single filers: Between $160,001 and $214,000 Joint filers: Between $320,001 and $428,000 $48.30 Single filers: Above $214,00 Joint filers: Above $428,000 $66.60
5.7 - Complaints and Appeals Regarding Part DWhile complaints regarding prescription drugs and Part D drug plans are varied, they are usually related to two things—covered drugs and payments. In either case, the beneficiary has the right to file a complaint with the plan, which is called a grievance. The process starts with a call to the Part D plan sponsor, whether it’s a stand-alone plan or part of an MA plan, requesting a determination of the grievance. If the plan decides against the beneficiary, then five levels of appeals are available. These appeal levels are similar to those that apply for a Medicare claims appeal. For review, they are:
Level 1: appeal to the plan (a “redetermination”)
Level 2: appeal to an outside independent review organization (a “reconsideration”)
Level 3: appeal to an administrative law judge
Level 4: appeal to the Medicare Review Council
Level 5: initiate civil action, to be heard in a federal court
appeal through the plan (called a redetermination)—The beneficiary must request this appeal within 60 calendar days from the date of the coverage determination. A standard request must be filed in writing, unless the plan accepts requests by telephone. The beneficiary, appointed representative, or doctor can ask for an expedited request. The plan will be expedited if the plan determines or the doctor tells the plan that the beneficiary’s life or health will be seriously jeopardized by waiting for a standard decision. Once the plan receives the request for an appeal, the plan has seven days (for a standard request or for a request to pay the beneficiary back) or 72 hours (for an expedited request for coverage) to notify the beneficiary of its decision.
review by an independent review entity (called a reconsideration)—If the plan decides against the beneficiary, beneficiaries can request a review by an independent review entity (IRE). Rules for this request are similar to those associated with Level 1 above.
hearing with an administrative law judge—If the IRE agrees with the plan’s decision, the beneficiary can request a hearing with an administrative law judge (ALJ). To receive an ALJ hearing, the projected value of the denied coverage must meet a minimum dollar amount (combined claims are allowed).
review by the Medicare Appeals Council—If the ALJ agrees with the plan’s decision, the beneficiary can request a review by the Medicare Appeals Council (MAC). This request must be made in writing, within 60 days from the date of the notice of the ALJ’s decision.
review by federal court—If the MAC agrees with the plan’s decision, the beneficiary can request a review by a federal court.
In addition, Medicare has made available a toll-free telephone number and Web site for complainants to discuss their complaint with a Medicare official after a redetermination.
5.8 - Marketing of Part D ProductsMost of the requirements for marketing Part D from a general Medicare Advantage standpoint were discussed in Chapter 4. As a review, the guidelines for those marketing requirements come from CMS guidelines and are directed to MA companies. MA companies, in turn, are to relay these guidelines to their producers through normal company channels. However, there are additional guidelines for marketing Part D products. So, let’s summarize those procedures, relying on the CMS basic regulations as they relate to both companies and producers. Part D Marketing ProceduresFirst, companies must provide a pharmacy ID card to enrollees. On the front side of the card must be the name or logo of the benefit administrator and/or processor issuing the ID card, including co-branding symbols and logos and the card issuer’s ID. Also, the card must include:
the cardholder’s identification number, which cannot be the Social Security number or health care insurance claim number. The plan or the claim administrator generates the cardholder’s ID number;
the cardholder’s first name, middle initial, and last name;
electronic transaction routing information;
the CMS Part D contract and plan benefit package numbers; and
the Medicare symbol.
The back of the card must contain:
the claims submission names and address;
customer service numbers;
customer service TTY/TDD numbers;
bar coding, where required by state law;
optionally, Medicare contact information;
benefit administrator Web site information; and
the phrase “Medicare limiting charges may apply.”
Secondly, Part D plans must include within their marketing materials information about their participating network pharmacies and must provide this information upon beneficiary request. At the time of enrollment, the MA organization must disclose clear, accurate, and standardized information regarding the plan and must include it in their provider directory. The provider directory must include the number and addresses of providers from whom enrollees may obtain services as well as any out-of-network coverage or point-of-service options. The directory must also include names, addresses, and telephone numbers of the primary care physicians, specialists, skilled nursing facilities, hospitals, outpatient mental health providers, and pharmacies where outpatient prescription drugs are offered by the MA plan. The provider directory must be presented at least annually to each enrollee.
Included must be general information about network lock-in, a description of the plan’s service area, telephone numbers for customer service or contact information, and information regarding out-of-area coverage and emergency coverage.
When producers explain Part D coverage, they will encounter and use the wordformulary. As explained previously, a formulary is a listing of the drugs covered by the plan. The plan must provide the definition of formulary, indicate how the formulary impacts any one of the plans, and explain how to use the formulary guide. (A single plan may have as many as many as four formularies.) The following statement must be included in the plan’s marketing material:
[Plan Name] covers both brand-name drugs and generic drugs. Generic drugs have the same active-ingredient formula as a brand-name drug. Generic drugs usually cost less than brand-name drugs and are rated by the Food and Drug Administration (FDA) to be as safe and effective as brand-name drugs.
Marketing materials must also include the following disclaimer: “This is not a complete list of drugs covered by the Part D plan. For a complete listing please call [customer service telephone number] or log onto [plan’s Web site address].”
The fact that the formulary can change during the year must also be stated, as must an explanation of how to obtain an exception to the Part D plan’s formulary, utilization management tools, or tiered cost sharing.
Prescription drug plans are required to provide evidence of coverage (EOC) to all enrollees annually. The EOC must include the plan’s service area, the annual deductible amount, initial coverage limits, and cost sharing between the initial coverage limits and the annual out-of-pocket threshold. Major exclusions and limitations must be stated, as must all monetary limits and any restrictive policies that might impact an enrollee’s access to drugs or services. The EOC must also explain how to access benefits, state that extra help is available to people with limited incomes, and describe the grievance, coverage determinations, and exceptions process, as well as appeal rights and procedures. It must also describe disenrollment rights, responsibilities, and procedures.
Prescription drug plans must also send an explanation of benefits (EOB) to enrollees in any month during which enrollees may use their benefits. This EOB is similar to EOBs sent by Medicare supplement companies to their policyholders, so MS/MA producers should be familiar with it. The EOB must include:
the items or services for which payment was made and the amount of the payment;
a notice of enrollees’ right to request an itemized statement, their appeal/grievance rights, and the exceptions process;
the cumulative, year-to-date amount of benefits relating to any deductible for the current year, the initial coverage limit if there is one, and total out-of-pocket expenditures;
the cumulative year-to-date total of incurred costs to the extent practicable; and
any applicable formulary changes for which the plan is required to provide notice.
With regard to the marketing for both companies and producers: no company or producer may discriminate based on race, ethnicity, religion, gender, sexual orientation, health status, or geographic location within the service area. In addition, these discrimination factors apply to targeting of advertising, such as only to high-income areas or only to certain prospects enrolled in Medicare, such as the over-age-65 beneficiary group, as opposed to those under 65. MIPPA 2008 Marketing ProtectionsThe Medicare Improvement and Patient Protection Act incorporated a number of protections for Medicare beneficiaries with regard to how both MA and Part D plans may be marketed. These protections were proposed by CMS in May 2008. By incorporating them into its provisions, MIPPA made them law. The marketing guidelines for MAPD and stand-alone PDPs are the same as those discussed in Chapter 4 for all MA products. Study these regulations in detail to avoid running afoul of the current marketing parameters established by CMS as well those outlined in MIPPA 2008. These requirements include the following:
a prohibition on cold calling and an expansion of the current prohibition on door-to-door solicitation to cover other unsolicited circumstances. Any appointment with a beneficiary to market health-care-related products must be limited to the scope that the beneficiary agreed to in advance. Cross-selling of non-health-care-related products to a prospective MA or Part D enrollee is prohibited;
a prohibition on sales activities at educational events, such as health information fairs and community meetings or in areas such as waiting rooms where patients primarily intend to receive health-care-related services;
strict adherence to “Scope of Appointment” rules, particularly in reference to whether an appointment is for the purpose of discussing Part D only, or whether the consumer is interested in discussing MAPD. There is a difference, and the agent must be aware that if the consumer wishes to discuss Part D only and has initialed that box on the SOA, the agent cannot begin a discussion of MAPD unless the consumer signs another “Scope of Appointment” form for another discussion of MAPD;
a limit on the value and type of promotional items offered to potential enrollees;
the requirement that MA organizations using independent agents to market MA and Part D plans use only state-licensed and company-certified agents for this purpose;
the requirement that MA organizations establish commission structures for sales agents and brokers that are level across all years and across all MA plan product types (for example, HMOs, PPOs, and private fee-for-service plans). Commission structures for prescription drug plans also must be level across the sponsors’ plans. These requirements are designed to discourage “churning” of beneficiaries from plan to plan each year in a manner that earns agents and brokers the highest commissions and ensures that beneficiaries receive the information and counseling necessary to select the best plan based on their needs; and
clarification to one approach to calculating fines, or civil monetary penalties, against Medicare Advantage or Part D plans that violate Medicare rules in ways that adversely affect beneficiaries. CMS would have greater flexibility in determining penalty amounts and would have clear authority to levy a penalty of up to $25,000 for each enrollee affected, or likely to be affected, by the violation.
There has been a great deal of frustration among insurance producers regarding the sale of Part D “stand-alone” products. Because an agent is only allowed to discuss his or her own plans, both the client and the agent are limited in what the client expects the agent to do when it comes to comparing their plan with another. Other complications arise with the limited timeframes in which consumers and agents are allowed to discuss MA/MAPD/PDP plans. A serious discussion of Part D plans involves a lot of time, and agency forces across the country feel that Medicare and CMS have “used” them to sell the Part D product for a very small commission. As a result, many agents who would have preferred to help Medicare enrollees have instead had to refer them to “Medicare.gov” and the subsequent “Part D Drug Finder” program accessible from this same Web site. During 2012, CMS made great strides in simplifying the navigation of the Part D Drug Finder. In addition, some MAPD plans have started to offer only one “basic” plan and one “enhanced” plan, which will enable enrollees and producers to draw meaningful comparisons between plans from the same sponsor.
5.9 - SummaryThis chapter presented information about Part D implementation and marketing. You will have gained an understanding of the foundations of the Part D program, which should help you in marketing terminology and specifications of Part D. As this chapter described, the problems in the introduction of Part D have mostly been overcome, and sales of the product from this point forward should be relatively simple if the rules are followed regarding stand-alone Part D and MAPD. Low-income assistance is within the realm of Medicaid—you should not involve yourself in advising clients on Medicaid, other than to direct them to seek correct information from Medicaid authorities. Also, this chapter cautioned against signing someone to a Part D plan who is currently on a group health insurance plan with an employer. Complaints should be directed to the company. Again, producers must remember that all MA, MAPD, and PDP plans are agreements between CMS and the various companies for a period of one year. This means that many plans will change annually. Therefore, the producer must familiarize him- or herself with the provisions of a client’s current plan when comparing it with any new plan.

4.1 - Medicare Advantage Marketing GuidelinesThe introduction of Medicare Advantage and Medicare Part D was complicated by a significant number of marketing problems. In this chapter, we will look at some of these problems and identify the events and processes that found their way to five congressional hearings in 2007. Many of these problems could have been avoided had MA companies been more diligent in training their sales producers and representatives in CMS marketing guidelines and requirements.
Upon conclusion of this chapter, you should be able to
understand the problems that occurred with the introduction of Medicare Part C and Part D and why these problems arose;
explain how the problems could have been avoided;
know what is required in marketing MA plans;
identify what is not allowed in the marketing of MA plans; and
understand the proper procedures for MA plan enrollments.
Most of the correctible problems had been addressed by the time of the hearings and have been prescribed by CMS and implemented by the MA companies. So, those errors should not continue. It is important that you understand the problems that occurred so as not to duplicate them in your sales efforts. You should also understand what is allowable and what is not allowable in marketing MA products and whether the products include Part D benefits—that issue is the emphasis of this chapter. In addition, understanding the correct enrollment timelines and procedures will help you to avoid mistakes in this area. Lastly, this chapter presents discussions of voluntary disenrollment and involuntary disenrollment.
4.2 - The Background to Problems that Surfaced EarlyUnfortunately, in the rush to introduce both Medicare Part C and Medicare Part D as created by MMA 2003—a short timeframe of roughly two years—many marketing problems occurred. Not only did Medicare Advantage companies have to prepare for the introduction of their plans, but thousands of federal government employees, state government employees, Department of Health and Human Service employees, county employees, and social workers had to transfer 6 million Medicaid recipients into Medicare Part D. Insurance agents and their companies were doing the same thing: enrolling dual eligibles in their MA Part D plans and introducing their new programs to their regular customer base.
The timeframe was tight, but the Part D transitions and sales were accomplished amidst a background of confusion for consumers, federal and state employees, insurance companies, and insurance agents. Because the enrollment into an MA plan that included the new prescription drug Part D benefit was a relatively easy process, some of the thousands of producers and dozens of companies may have overlooked the most prudent marketing techniques. And those improper sales techniques surfaced. In fact, they surfaced to a media roar, which found its way to Congress early in 2007.
No fewer than five congressional committee hearings were held in the spring of 2007. The complaints were in two major categories. The first was that MA companies had been allowed to take advantage of an “unlevel playing field” promulgated by what some authorities regarded as much greater payment rates by Medicare—as much as 7 to 12 to 19 percent more than allowed as reasonable by Original Medicare’s fee-for-service payment rates. This problem prompted legislation in both the House and Senate, as lawmakers tried to devise ways to lower the payment rate to MA companies. Proponents of the legislation regarded the payment rates to Medicare Advantage as excessive, thereby creating a fiscal crisis for the Medicare program itself. Opponents of the legislation complained that payment cuts would result in a loss of up to 33 percent of MA enrollees—approximately 3 million of the 8.4 million MA enrollees, many of them at poverty level.
The second factor spurring congressional hearings was the improper marketing practices of Medicare Advantage sales people. Though this problem was legitimate and serious, its scope as measured against the number of Medicare-eligible people—and the percentage of these people who were affected by it—was small. Nonetheless, the issue of improper MA sales and marketing practices became a snowball. It followed a path not uncommon to any in which individuals are dissatisfied or unhappy with their purchase—perhaps because of a time crunch in which to make a decision or because of finances or an inappropriate sales presentation, or even because of an illegal sales presentation. This dissatisfaction can occur in any transaction, but in the case of an insurance transaction, an entire industry—and its sales force—are often broadbrushed as “high pressure.”
Complaints against insurance companies or insurance producers usually start with seeking help through state insurance departments. With the case of consumer complaints against MA plans, this did little good. Of the seven regulatory oversight functions that state insurance departments normally have with insurance companies and insurance producers, five had been restricted to CMS alone—MMA 2003 had purposely left these regulations outside of state insurance regulation and control. So, when individuals complained to state insurance departments, they were told that the state has little or no ability to oversee the marketing practices of any MA producers—the mantra became “call Medicare.” So, the next stop, if complainants wished to proceed, was to call Medicare and wait on a phone line endlessly to make their complaint.
This process seldom satisfied anybody, so logically, the next stop was to call the newspapers. Most journalists know little, if anything, about insurance, but writing a news article about insurance companies and their agents appealed to reporters seeking an “exposé.” So, hundreds, if not thousands, of stories were presented in the various media about the corrupt practices of Medicare Advantage insurance producers and their companies.
Legislative bodies were next to be called to provide remedy. By the spring of 2007, Congress was investigating the matters, which, by the summer of 2008, found their way into the legislation of MIPPA 2008. Undoubtedly, over time, CMS will have to hand over some of the oversight to state insurance departments, because these state agencies are the first parties asked to look into any other insurance marketing practices.
4.3 - CMS Guidelines Attempted to Limit Problems at the BeginningIn fairness to CMS, many of the marketing practice complaints, which progressed from phone calls (either to CMS or to state insurance departments), to the media, to Congress, were already being addressed by the time they made their way to Congress. In fact, CMS had laid out the rules at the beginning of the MA process. These rules were specified in marketing practices issued to MA companies before MA sales began.
The publication, Medicare Marketing Guidelines For: Medicare Advantage Plans (MAs), Medicare Advantage Prescription Drug Plans (MAPDs), Prescription Drug Plans (PDSP), and 1876 Cost Plans, was originally published on August 15, 2005, and is continually revised. This document outlines required marketing guidelines and practices for MA companies. The problem was that CMS expected the guidelines to be passed down to producers through company channels that were sometimes less than efficient. As it turned out, many producers were sent into the field without having been given Medicare’s marketing guidelines.
In fact, before (and since) the marketing practice complaints surfaced, MA companies have had additional marketing advisories and guidance issued to them by CMS. One attempt to solve the marketing problem is the requirement that Medicare Advantage companies recertify their producers every year. Another practice is to terminate the contracts of producers who are found to have violated the marketing practices passed down from CMS to the companies. However, for most companies, marketing practice violations had already propagated, and so damage control was already in effect.
When MA companies first began marketing their plans, nearly any producer could be appointed with an MA company. All he or she had to do was take an internet training module and then answer a few questions regarding the product and some marketing rules. Unfortunately, these training modules taught little about Medicare background or the differences between Medicare, Medicare Advantage, and Medicare supplements. In other words, most broker appointments could be made without the broker having a real understanding of the issues, and only a basic knowledge of the particular company plan. The “recertifying” procedures of 2009 (for plan year 2010) rectified much of the problems just described, and independent MA/MAPD/and stand-alone PDP producers were held to far stricter standards, considering the history of MA marketing practices. As expected, the recertifying standards are now necessary each year.
On the other hand, MA company career agents were well-educated, having received two to four weeks of intense company training. These producers were trained in serious marketing practices and marketing practice violations. Brokers or noncaptive agents who did not receive such intense training—who were, in fact, rushed through the process—were not prepared to adequately or appropriately represent and sell MA plans. It was from this quarter that the raft of legitimate marketing and sales complaints arose, which brought about the strict recertifying standards, which require that any agent or producer who sells MA or PDP plans recertify each year.
4.4 - Problematic MA Sales PracticesFollowing are some, but by no means all, of the MA complaints presented to Congress. They are listed in no particular order. Note that the majority of MA producers were, and are, on the right track. Unfortunately, it was the ill-informed, undereducated, or less than honest producers (and the companies that did not stop their activity) who created havoc for the entire industry, as the following examples show.
The insurance department of the state of Georgia reported that it had received more than 300 written complaints charging misleading practices and fraud, as well as hundreds of phoned-in complaints. Two insurance agents were arrested in April of 2007 and charged with using deceased individuals’ information out of agency databases to write fraudulent MA policies. In addition, Georgia investigators found that some agents told beneficiaries that they needed to verify that the beneficiaries were covered under a stand-alone Medicare Part D plan. The agents had the prospective enrollee sign a form that they said would show that the enrollee’s choice of Medicare Part D had been verified, when, in fact, the form was a Medicare Advantage enrollment form.
Agents mislead senior and disabled citizens into switching from traditional Medicare and Medicaid coverage to private health plans under MA. This charge included signing up seniors for coverage they didn’t need, didn’t want, or couldn’t afford.
Agents, forging applications, told beneficiaries that Medicare would be discontinued.
Agents signed up deceased people.
Agents used high-pressure tactics and aggressive and frequently misleading advertising to enroll prospects in MA plans. MA insurance companies were accused of a lack of responsiveness, making it difficult for people to cancel their coverage or disenroll. MA companies were said to have told people they could not disenroll and that they were locked in, even though they were victims of marketing abuse.
Agents posed as Medicare employees and signed up people in nursing homes, group homes, and group settings after seminars.
People complained that (1) they were embarrassed into thinking they needed the coverage; (2) they were confused about what they had signed up for; and (3) they didn’t realize that they had been disenrolled from traditional Medicare and from their Medicare supplement plan. Obviously, these people were extremely angry with their MA agents after finding out what had happened.
People were generally uneasy and confused over the bewildering array of MA plans.
Agents signed up people with Alzheimer’s and psychiatric disorders.
Agents forged signatures.
Agents told clients that the MA plan they represented was a supplement, but actually the agents were replacing a Medicare supplement.
Agents told people that Medicare was being eliminated and that they must sign up for MA or lose their health coverage.
Agents used attendance logs at informational meetings to switch people to MA without their knowledge.
Agents refused to leave a client’s home until they had a check for an MA plan.
Agents were accused of “predatory” sales practices.
Agents went to low-income developments and started enrolling people.
Agents told people that they could keep their existing MA policies while buying another MA policy.
Agents failed to tell clients that some doctors might not accept the MA coverage.
All professional producers should look at this list and be careful to avoid any of these practices in their own MA sales. Ethical producers have no need to resort to any questionable tactics. The MA sale is easy enough, and the compensation rewarding enough, that professional producers need not take a chance on losing their appointments (or even their insurance licenses) or their livelihoods by using any questionable marketing tactics. The rules set down by CMS and each MA company are easy enough to follow, and the time will come when an inadequate education of Medicare, Medicare Advantage, Medicare Part D, and Medicare supplements will be no defense against the unscrupulous actions of the unethical producer. In view of these listed citations, the time for education should have been at the outset of MA sales. These problems clearly illustrate the need for continuing education in Medicare Advantage on an individual or group basis.
A valid criticism regarding MA marketing lies in the history of Medicare supplement sales. Many of the charges are the same ones that were solved in Medicare supplement marketing practices years ago. However, without state insurance departments being able to regulate and investigate MA problems, their hands are tied. And unfortunately, CMS does not have the funds, the manpower, or the will to investigate thousands of charges. CMS now requires that MA companies regulate themselves—in other words, CMS regards the actions of an individual producer as being the actions of the companies—and requires that companies assure CMS that their representatives are acting within the law.
4.5 - CMS Marketing GuidelinesNow that we know what the problems are, we can turn to the solutions. The answer to proper and appropriate MA sales and marketing practices lies within the guidelines originally set forth by CMS. These original guidelines have since been expanded and strengthened with additional directives issued every year.
In addition, provisions of MIPPA 2008 also addressed sales and marketing activities, effectively prohibiting certain practices in the sale and marketing of MA and Part D plans, thereby putting some “legal teeth” into CMS guidelines.
For openers, all Medicare Advantage companies and all MA producers must comply with the CMS document mentioned earlier: Medicare Marketing Guidelines For: Medicare Advantage Plans, Medicare Advantage Prescription Drug Plans, Prescription Drug Plans, and 1876 Cost Plans.
The opening paragraph of this document reads, in part, as follows:
These marketing guidelines reflect CMS’ current interpretation of the marketing requirements and related provisions of the Medicare and Medicare Prescription Drug Benefit rules. . . . These guidelines were developed after careful evaluation by CMS of current industry marketing practices, recent advancements in communication technology, and how best to protect the interests of Medicare beneficiaries. The marketing guidance set forth in this document may be subject to change as communication technology and industry marketing practices continue to evolve, and as CMS gains more experience administering the Medicare Prescription Drug Benefit and Medicare Advantage programs.
While not specifically addressing producers, the guidance is published for the MA companies or organizations selling the MA product. There are several references to MA company compliance regarding what is and is not allowed in marketing. That information and these requirements then automatically revert to any MA agent or producer. It is up to the MA company to educate and train its producers on the marketing of its product in accordance with the CMS marketing guidance. Thus, the MA company must “pass down” these guidelines and add its own company-specific marketing practices, objectives, and product training. Private Fee-for-Service Plans DirectiveIn addition to the original rules, others had to be developed. Most of the complaints regarding MA plans resulted from the rush to introduce and enroll Medicare recipients in new private fee-for-service plans. Consequently, CMS had to develop further guidance and “corrective action” plans. Generally, PFFS plans were fined not for agent indiscretions but for failure to send timely information to beneficiaries.
Because of the need for corrective action, CMS issued a directive to Medicare Advantage PFFS plans on May 25, 2007, which addressed the problems of education and information. The problems (and solutions) were described as follows:
. . . CMS is providing additional model documents and requiring new outreach processes to ensure beneficiaries and providers are informed about the distinctive features of Medicare PFFS plans. MA organizations offering PFFS plans are strongly encouraged to implement these new elements and practices as quickly as possible. Several of these must be implemented immediately. . . . All PFFS organizations must have these processes in place prior to marketing [their] 2008 PFFS plans.
Note that this directive was submitted at approximately the same time that a moratorium on individual sales of PFFS plans for seven major companies was agreed upon. Obviously, the point of the May 25 directive was to correct the marketing problems immediately for PFFS companies to be able to resume sales.
Listed next are the major additional corrective marketing process procedures that the directive requested:
sales presentation schedules—Requires monthly reporting and listing in advance to CMS of planned PFFS marketing and sales events, including both employed and contracted sales representatives.
prohibition against implying that private fee-for-service plans function as Medicare supplements—Prohibits any materials or presentations that imply that PFFS plans function as Medicare supplement plans or use terms such as “Medicare supplement replacement.” MA organizations may not describe PFFS plans as plans that cover expenses that Original Medicare does not cover nor as plans that offer Medicare supplement benefits. It is permissible, however, for PFFS plans to clarify that the plan does not pay after Medicare pays its share, but rather it pays instead of Medicare, and the beneficiary pays any applicable cost sharing or co-payments.
PFFS marketing material disclaimer—MA organizations offering PFFS plans are required to prominently display the following disclaimer in all advertisements and enrollment-related materials:
A Medicare Advantage private fee-for-service plan works differently than a Medicare supplement plan. Your doctor or hospital must agree to accept the plan’s terms and conditions prior to providing health care services to you, with the exception of emergencies. If your doctor or hospital does not agree to accept our payment terms and conditions, they may not provide health care services to you, except in emergencies. Providers can find the plan’s terms and conditions on our Web site at: (insert link to PFFS term and conditions).
This language is also required in sales presentations in public venues and private meetings with beneficiaries. Any statement indicating that enrollees may see any provider must also include the phrase “who agrees to accept our terms and conditions of payment.”
beneficiary and provider leaflet—All MA organizations must provide enrollees with a complete description of plan rules, including detailed information on a provider’s choice of whether to accept plan terms and conditions of payment. The leaflet must be included in all enrollment kits that prospective enrollees receive.
outbound education and verification calls—All MA organizations offering PFFS plans are required to conduct outbound education and verification calls to ensure beneficiaries requesting enrollment understand the plan rules. It is important to obtain from the beneficiary the verification phone number and provide a description of the enrollment verification process to the beneficiary during the application process. The approved enrollment application form must accommodate this requirement. “Outbound calls” are calls made to the beneficiary after the sale has occurred; calls cannot be made at the point of sale. The verification calls made to beneficiaries who request enrollment through sales agents cannot be made directly by those sales agents. In addition, sales agents cannot be with the beneficiaries at the time of the verification calls.
PFFS enrollment processing—The special processes and marketing practices described in the directive are designed to ensure that new enrollees have all of the required information to understand the plan in which they are enrolling. Conducting this outreach and education does not change the requirements to which all MA organizations must adhere for processing MA enrollment requests.
Several other items are directed to MA companies regarding best practices, but they are not particularly pertinent to producer instructions for enrollment procedures. So, let’s now review what producers must do to secure compliance with all MA ethical and legal requirements. These directives apply to all MA/MAPD producers. MA Producer QualificationsTo properly (and legally) represent and sell an MA plan, a producer must
have a valid insurance license, either resident or nonresident, in any state in which he or she solicits business;
successfully complete the training courses of any MA company that he or she wishes to represent. This training may consist of electronic training or classroom-style training and will include exams relating to the company product, CMS guidelines, and compliance;
be certified by the company being represented by submitting company appointment papers and possibly proof of errors and omissions insurance, passing the certification course exams, and paying appointment fees, if any. Company appointment papers may include a section on “Specific Regulatory Obligations of Medicare Participation.” (These regulatory obligations can also be found under a “Termination for Cause” clause.) The regulatory obligations regarding sales practices include:compliance with laws
business integrity
maintenance of records, audits
delegation
suspension, revocation, or termination of sales agreement
monitoring
compliance with the company’s obligations
federal policies; flow-down provisions
nondiscrimination rules; and
recertify each year by completing updated training requirements as directed by the MA company. Recertification may include, among others, the following:
confirmation of state licensure
extensive criminal background screening
mandatory training and testing on product benefits and marketing guidelines and a score of at least 85 or 90 percent, depending on the test
mandatory contract terms, incorporating a sales agent code of conduct
onsite monitoring of agents by field sales management
post-enrollment outreach calls to 100 percent of new members
mandatory retraining and retesting to refresh knowledge of plan terms and marketing guidelines
rapid resolution of any identified compliance issues
zero tolerance for verified infractions
Scope of Appointment Form and RequirementsMIPPA 2008 specifically states: “A MA or Part D plan may not market any health care-related product during a marketing appointment beyond the scope agreed upon by the beneficiary and documented by the plan, prior to the appointment.” In other words, the scope and purpose of the meeting (appointment) must be understood and agreed to by a consumer before the scheduling of any sales meeting.
In compliance with that law, CMS has developed strict pre-enrollment procedures that must be completed before a producer actually takes an application for enrollment in an MA/MAPD or PDP plan. The basic rule requires a Scope of Appointment (SOA) form, which the prospect must complete and which both the prospect and the producer must sign before any sales meeting occurs or before any MA or Part D program can be discussed. The purpose of the SOA is to define the scope of the meeting that will occur between a producer and a prospect, including the specific plan that will be discussed.
The form has seen variations from CMS, and some companies have enhanced their own forms, but a generic form was established so that a producer could represent more than one company at a particular appointment. The Scope of Sales Appointment Confirmation Form presented at the end of this chapter was CMS approved in September 2009. Before we visit the actual form itself, the procedural use of the form as outlined by CMS is presented below. The following rules are from a letter from CMS, dated February 11, 2009, to Medicare Advantage organizations.
Instructions for Scope of Appointment Documentation
When is the Scope of Appointment form required?
The scope of appointment form is required under the following circumstances:
in-home sales appointments or personal/individual appointments with an existing member/client in an office, coffee shop, or other similar location;
appointments with new members/clients (not existing members/clients); and/or
when a plan or agent/broker sells more than one type of product.
If a beneficiary requested to discuss another product during their appointment (e.g., MA during a PDP appointment), is the agent/broker required to complete a new Scope of Appointment documentation form?
A new Scope of Appointment form is required if the beneficiary has asked to discuss another product type during the appointment. However, a new appointment is not required. The additional product can be discussed as soon as the beneficiary request is documented.
Should the Scope of Appointment form be completed prior to the appointment?
The Scope of Appointment form should be completed by the beneficiary and returned prior to the appointment. If it is not feasible for the Scope of Appointment form to be executed prior to the appointment, an agent may have the beneficiary sign the form at the beginning of the marketing appointment.
How should the Scope of Appointment form be documented?
CMS-approved Scope of Appointment form (either model or nonmodel)
CMS-approved oral/recording Script of the Sales Appointment Confirmation
CMS-approved business reply card
Organizations are allowed to use various means for appropriate documentation (e.g., fax, email, etc.)
Is the Scope of Appointment form required at sales events?
Sales events do not require documentation of the beneficiary agreement because they are not personal/individual appointments.
The scope of products that will be discussed during a sales event must be indicated on all event advertising materials.
Beneficiaries are not required to complete and sign the Scope of Appointment form prior to participating at a sales event.
Beneficiaries may sign a Scope of Appointment form at a sales presentation to a group of beneficiaries for a follow-up appointment. (The follow-up appointment does not need to be held 48 hours later; it may be held at the venue immediately following the sales presentation.)
Can brokers or agents selling for more than one plan use the model Scope of Appointment form for all their contracted plan sponsors?
Because there are no organization-specific details in the model Scope of Appointment form, the model form can be used by agents for multiple organizations.
In addition, there are other guidelines that must be followed and that are helpful to the producer:
Scope of Appointment procedures may be followed by “inbound” calls to the producer or a company from a prospect, which must be recorded.
Beneficiaries consent in advance to the product information to be discussed during a sales call; therefore, the SOA process must be completed prior to conducting the sales appointment, no matter where the sales meeting will be held (client’s home or agent’s office). SOA is not required if an agent is meeting beneficiaries at an educational seminar. Direct sales leads are not regarded as satisfying SOA requirements, or in lieu of a completed SOA. The SOA paper form must be sent to the prospect via mail, fax, or e-mail. The form may not be dropped off at a prospect’s home. The paper form must be signed and dated by the prospect and returned to the agent before an appointment can begin. In addition, the form must be signed and dated by the agent before the appointment can begin. The paper form must be submitted to the company along with enrollment papers. The form must be retained in the agent’s records for ten years. The SOA can be completed at point-of-service just prior to a sales meeting in the agent’s office. In these cases, the agent must write “Beneficiary Walk-In” on the application. If the prospect wants to discuss other products, such as life insurance, annuities, long-term care, etc., the agent must set up another meeting after a 48-hour period beyond the end of the original meeting. The boxes on the SOA form are for the client’s initials, not “Xs.” Agents cannot call a potential client unless they have permission through a lead card or other form of response that the person wants more information. Agents cannot call a referral or ask for a referral’s phone number. The referral must initiate the call, so a customer who offers a referral must notify the referee of this information.
Enrollment Procedure GuidelinesOnce the requirements for the Scope of Appointment have been met, the agent can schedule an appointment meeting with the client. Several steps are involved in what a producer must do during the course of an MA sale. The first of these is following the guidelines that define how an individual enrolls in an MA plan. These enrollment guidelines must be conducted in accordance with company and CMS regulations:
The producer must thoroughly explain the product to eligible Medicare beneficiaries. The producer should make certain that the prospect comprehends the product and is competent to make his or her own decisions.
The producer must ensure proper and total completion of the enrollment form in accordance with training manual instructions, including answering all questions correctly. The producer must not alter or omit the prospect’s responses on the application. Applications must be completed accurately and clearly—in other words, cleansheeting (not accurately recording the prospect’s answers to questions) is prohibited. Prospective members’ signatures or their authorized representatives’ signatures must appear on all applications.
In addition to the normal enrollment questions, the producer must ask the following specific enrollment questions and take these actions:
Are you currently on Medicaid? (The producer should indicate the Medicaid number if the prospect answers “Yes.”)
Mark the correct choice of plan. Do you have end-stage renal disease? (Medicare beneficiaries cannot be denied membership in a Medicare Advantage plan because of poor health, a disability, or a pre-existing condition, with the exception of end-stage renal disease.) Are you currently in a nursing home or long-term care facility? Mark any special election period (SEP) statements.
Stop and read aloud to the enrollee the following statement: If you currently have health coverage from an employer or union, joining this plan could affect your employer or union health care benefits. If you have health coverage from an employer or union, joining this program may change how your current coverage works. Read the communications your employer or union sends you. If you have questions, visit their Web site, or contact your benefits administrator or the office that answers questions about your current coverage. The producer must submit the enrollment form in a timely manner to the MA company via fax or mail, in accordance with training manual instructions. Enrollment forms must be complete—missing information may delay processing and the effective date of the application. Applicants, however, have 30 days after being contacted by the company in which to submit missing information. If additional documentation is not received within 45 days, the company will send a “Denial of Enrollment” letter. The enrollee must be familiar with the terms lock-in or lock-in period. Lock-inmeans that if an MA enrollee elects and enrolls in a plan during the annual enrollment period (October 15 through December 7), he or she is essentially “locked in” to that plan until the next annual enrollment period. During the annual enrollment period, an enrollee can change from one plan to another, but the plan in which he or she is enrolled as of December 7 becomes the final choice. However, keep in mind that the enrollee can disenroll from a plan during the annual disenrollment period. And if circumstances permit, the enrollee might be able to use rights under the special enrollment period. The enrollee must be notified of reasons for possible disenrollment: The member fails to pay the monthly premium on a timely basis, if a premium is involved. The member is disruptive for reasons unrelated to use or application of medical services, and the behavior prevents treatment to him- or herself or to other members of the plan. (CMS must first approve disenrollment for this reason.) The member commits fraud. The member knowingly permits misuse of his or her membership card. The member permanently moves out of the service area. The member temporarily moves out of the service area for an uninterrupted absence of more than six months. The member loses entitlement to Part A or Part B Medicare benefits. The member dies. The member was found to have inappropriately used an incorrectly appointed power of attorney to represent him or her during the enrollment. A member must be disenrolled for the following reasons:
Producers of PFFS plans must indicate that these plans are not Medicare supplements and are not Medicare supplement replacements. In sales presentations in public venues and private meetings with beneficiaries, the producer must state that an MA PFFS plan works differently than a Medicare supplement plan. Any statement indicating that enrollees may see any provider must also include the phrase “who agrees to accept our terms and conditions of payment.” Prospecting GuidelinesProspecting guidelines are important from a compliance standpoint. CMS and MA company guidelines must be followed. Failure to follow these guidelines constitutes cause for the producer’s termination.
First, a list of acceptable actions in prospecting explains what the agent can do to remain within the guidelines for prospecting. Allowable Prospecting ActivitiesThe agent may
ask members or prospective customers if they are members of a group, organization, or club;
look through the Yellow Pages of the service area to identify groups and organizations that may cater to the agent’s market;
introduce him- or herself to local government offices;
ask for referrals, but may not contact the referral—the referral must contact the agent;
network and build community relations;
leave business cards;
build a reputation as a trusted and knowledgeable resource;
attend and distribute materials at health fairs and senior expos;
visit with area providers—physicians and hospitals;
hold special events for members and ask them to bring friends; and
visit senior centers and church groups as a speaker.
What an Agent Must Not Do When Writing Medicare AdvantageWhat an agent must not do is as important as what he or she must do when writing or marketing a Medicare Advantage plan. The issues associated with the “what not to do” when marketing MA plans can be categorized into ethics and compliance. We’ll examine each. The Ethics of MA MarketingEthics is a strange topic. In the past few years, insurance departments have emphasized ethics in preparatory courses for obtaining an insurance license, have asked insurance continuing education vendors to introduce more ethics courses, and have also asked them to include ethics in more of the content they offer within other courses.
While an admirable quest, not even dozens of study hours on ethics and ethical practices affect those who don’t care about ethics. Either a person is ethical, or he or she is not. Furthermore, several interpretations and definitions of what is ethical exist. We won’t delve too deeply into this highly contentious topic. Instead, let’s simply acknowledge that two primary factors played a role in degrading ethical practices in marketing MA plans: compensation and time. Because of the time crunch of producing applications (“. . . this has to be done now, the money is here to be made now, and the whole thing may not last very long”), some producers took short-cuts to enhance their application count and their compensation. Those two factors—greed and time—played a major part in unacceptable marketing practices.
It is questionable whether ethics instruction will play a greater role than in the past. Those who are unethical simply must be eliminated from the business, and hopefully, those who are left are guided by ethics and “doing the right thing.” Ethical acts can be described as “an act that you would do, whether or not you knew that anybody else was watching or would find out about it.” The Compliance of MA MarketingCompliance is another very important facet of ethics in MA marketing, because it deals with the rules, legalities, illegalities, and obligations of MA companies and producers in relation to the guidelines found in both CMS and company guidance literature. In addition, the Medicare Improvements for Patients and Providers Act of 2008 also addressed MA marketing, thereby elevating some CMS guidelines into laws. The provisions of MIPPA took effect for plan years 2009 and later.
With respect to the marketing of MA plans, a producer may not
change any of the sales brochures, applications, rates, literature, or any other paper or advertising of the company. The materials have been approved by CMS and the company, and any alterations of these items are illegal and grounds for termination. Crossing out, blacking out, or whiting out is illegal.
cold call, solicit door-to-door, or make any unsolicited visits;
represent him- or herself as a representative of CMS, Social Security, Medicare, or the state insurance department, or any other government office. To do so is illegal. Such remarks as “Oh, we work with (any of the above) all the time,” or references to such, are also illegal.
advise prospects or members that they must purchase plans as directed by Medicare;
sell and/or enroll anyone where health care services are dispensed, except in common areas. Common areas where marketing activities are allowed include hospital or nursing home cafeterias, community recreation rooms, and conference rooms. If a pharmacy counter area is located within a retail store, common areas would include space set far off from the pharmacy itself, away from any spot where patients wait for services or interact with pharmacy providers and obtain medications. Locating a desk or kiosk near the pharmacy itself is illegal.
conduct telephone solicitation to Medicare members or hire a marketing firm to conduct telephone solicitations;
cross-sell related or unrelated insurance products, such as life insurance or annuities, which would violate the Scope of Appointment rule. A separate appointment will have to be scheduled at least 48 hours after the original appointment.
discuss a Medicare Advantage or combined MA/Part D plan at the same meeting, if the Scope of Appointment is for a Medicare Part D plan only. The reason behind this rule is that some consumers indicated they wanted Part D only and found they had been enrolled in a Medicare Advantage plan.
send unsolicited e-mails to prospects;
back-date any enrollment forms;
conduct discriminatory practices, such as pursuing business in affluent neighborhoods or poor neighborhoods, asking health questions for the purpose of selling the product, or conducting business in facilities not accessible to disabled individuals. Also, product marketing must be done in accordance with Title VI of the Civil Rights Act of 1964 without regard to race, color, religion, creed, age, national origin, or health status (except for prospects with end-stage renal disease) as provided by CMS guidelines.
offer prizes, gifts, or incentives with an individual or collective retail value of more than $15;
provide meals at promotional or sales events (though light snacks and beverages are allowed);
use “sign in” sheets at marketing events as Scope of Appointment forms and use these forms to follow up with the attendees to discuss any MA or Part D plan. Attendees may be given and may sign an SOA at a marketing event.
use materials other than those created by the MA company and approved by CMS;
ask a prospect health-screening questions, with the exception of the end-stage renal disease question;
approach consumers in parking lots, lobbies, or any other areas, because unsolicited contact of any kind is prohibited;
employ any high-pressure sales tactics, or any of the following:deception
coercion
scare tactics
dishonesty
intimidation
harassment;
use false or exaggerated statements when conducting a sale;
fail to ensure that all benefit details are thoroughly explained;
claim that the plan is recommended or endorsed by any governmental organization (which is considered false representation under CMS marketing guidelines);
sell MA or Part D products outside of the designated election (enrollment) periods of MA and Part D products, unless representing and selling a CMS-approved five-star plan;
assist a prospect in obtaining or implementing a power of attorney or any other such behaviors that might be construed as unethical sales practices;
accept any financial gifts, incentives, or other compensation from prospective members; or
imply that a PFFS plan functions as a Medicare supplement or use such terms as “Medicare supplement replacement.”
Two more cautions dealing with compliance in MA marketing address the importance of enrollment periods and advertising:
The agent must be familiar with the proper meaning and terminology associated with enrollment periods and their dates. Not being familiar with the terminology and the correct dates involved could lead to inappropriate enrollment dating, which is illegal. The currently effective enrollment dates are the following:
initial election period (IEP)—When the enrollee turns 65 (“aging in”). This is the seven-month period that begins three months before the month the individual turns 65 and concludes at the end of the third month following the month he or she turns 65.
annual coordinated election period (ACEP)—When Medicare beneficiaries can elect to enroll, drop, or change their enrollment in a Medicare Advantage and/or Part D plan. This period runs from October 15 through December 7 every year. (This period is also known as the fall open enrollment period or annual enrollment period.) annual disenrollment period—When Medicare Advantage and/or Part D enrollees can elect to disenroll from their MA or Part D plans and enroll in Original Medicare. This period runs from January 1 through February 14 of each year. This period is formally termed Medicare Advantage Disenrollment Period, or MADP. special election period (SEP)—Any time an enrollee is permitted entry to an MA or Part D plan because of certain special conditions. five-star plan enrollment option—At any time during the year, an enrollee can elect to enroll in a CMS-certified five-star MA plan. This is a once-a-year option and is only available to those who live in an area served by a five-star plan. Producers who represent CMS-approved five-star plans can market and sell those plans at any time of the year. This essentially allows an MA or a PDP producer to enroll anytime during the year in two cases: the initial election period and when representing a five-star plan. With regard to advertising, the producer must use only the advertising, brochures, forms, etc., that the MA company provides. As is the case with Medicare supplement advertising, companies use only materials approved by CMS and do not tolerate a producer’s attempt to go beyond approved materials for advertising or self-representation. Use of extraneous materials is cause for termination.
In addition to the above, many MA companies require their representatives to complete a “Marketing Sales and Marketing Code of Ethics” form with an initialized paragraph-by-paragraph understanding of the rules described above and an ethics generalization regarding the sale of MA and Part D products. Also, a “Marketing Practices Statement” is required by some companies, which agents must sign, attesting that they understand the rules. These devices are for the protection of the consumer, the companies, and the agents themselves.
MA/MAPD and PDP producers also need to be aware of the “marketing surveillance” techniques of CMS. CMS actually contracts with “secret shoppers” as part of its “secret shopper program” to attend events and individual “sit-down” appointments and to listen to a producer’s presentations. The purpose of this program is to identify agents who employ the kind of sales tactics that led to some of the marketing problems explained earlier in the chapter, which resulted in congressional action and additional CMS regulation. The surveillance program even monitors articles or advertisements by searching for key words. In addition, CMS has established partnerships with the departments of insurance in all states to report and cooperate in curtailing illegal practices through “Memorandums of Understanding.” This allows states to be involved in controlling questionable agent sales practices, which is a compliance measure that MMA 2003 did not provide for. Agents who choose to overlook the rules in light of the secret shopper list of possible violations are indeed risking losing their appointment as well as their insurance license should charges of this nature be substantiated. Enrollment Timelines and ProceduresAn eligible individual may enroll in a Medicare Advantage plan a number of times. Each of these periods has been given an identifying name (and associated acronym). Though other periods are available, the following are most commonly used:
initial election period (IEP)—Also known as initial coverage enrollment period, the key word is “initial.” This period is when an individual initially becomes eligible for Medicare. Accordingly, an individual may elect to enroll in a Medicare Advantage plan when he or she first becomes entitled to both Part A and Part B of Medicare. The initial election period begins three months before, includes the month of, and ends three months after a person’s birthday. This creates a seven-month initial election period.This is the same election period as the initial enrollment period of Medicare itself. In MA jargon, this period is known as the “aging in” period (when the enrollee turns 65) and allows the MA producer to enroll prospects who qualify under the IEP at anytime during the year. In other words, prospects within this initial period do not need to wait—coverage begins the first day of the birth month. The IEP rules are the same for all MA plans, regardless of whether they include prescription drug coverage. For those who are receiving Medicare disability benefits, the IEP for enrolling in an MA plan is seven months from the time that the individual receives Medicare disability benefits.
annual coordinated election period (ACEP)—Also known as fall open enrollment, or annual enrollment period, the key word is “annual.” This is the period every year during which Medicare beneficiaries can sign up for, drop, or change their enrollment in a Medicare Advantage or Part D plan. This period runs from October 15 through December 7.During this annual enrollment period, beneficiaries can elect to remain in their current Medicare Advantage plan, change to a new MA plan, or drop out of Medicare Advantage and enroll in Original Medicare. Those who are enrolled in Original Medicare can switch to an MA plan during this time. Also during this time, beneficiaries can add, change, or drop prescription drug coverage. The member can make one change per year to any plan, and can make more than one change during the AEP, but the plan in which he or she is enrolled as of December 7 will be the plan that becomes effective January 1 of the following year. The enrollee is locked into that plan. There is an exception to the lock-in: the enrollee may drop the plan during the Medicare Advantage disenrollment period between January 1 and February 14 of the next year; otherwise, he or she is locked into the plan until the next annual election period.
As noted, plans that obtained a “five-star” designation under Medicare’s star rating system are allowed to be sold at any time during the year.
Medicare Advantage disenrollment period (MADP)—This is the period during which individuals can disenroll from a Medicare Advantage plan or an MA Prescription Drug plan and enroll in Original Medicare (either with or without a stand-alone PD plan). This period runs from January 1 through February 14 of each year. New coverage is effective the first day of the next month following the change. Part D coverage can be added or dropped, and a Medicare supplement policy can be purchased.
special election period (SEP)—SEPS are special periods (anytime) during which an enrollee is permitted entry into or allowed to discontinue enrollment in a Medicare Advantage plan and change his/her enrollment to another Medicare Advantage plan or return to Original Medicare. The person may enroll in an MA plan if he or she is recently disabled or begins receiving assistance from Medicaid and does not have to wait until the October 15 (annual enrollment) period.
In the event of the following circumstances, a SEP is warranted:
The MA plan in which the member is enrolled is terminated, which is called involuntary disenrollment—involuntary loss of creditable coverage.
The enrollee permanently moves out of the service area or continuation area of the MA plan.
The Medicare Advantage company offering the plan violated a material provision of its contract with the enrollee.
The enrollee meets such other material conditions as CMS may provide, such as an involuntary loss of creditable group coverage.
Enrollment is delayed because an employer’s coverage or spouse’s employer group health insurance coverage is being terminated.
The individual experienced a recent disability.
The individual is receiving any assistance from Medicaid. This includes:full dual eligibles;
partial dual eligibles (Medicare Savings Program enrollees);
beneficiaries residing in long-term care facilities; and
other qualifications relating to long-term care facilities, creditable coverage, LIS (low-income subsidy) eligibility, Part D coverage, and other circumstances that give CMS discretion to create a SEP.
general enrollment period (GEP)—This is a little-used Medicare period from April 1 to June 30, with coverage effective July 1 for those who did not enroll in Part B at the time they became eligible for Part B.
The preceding dates notwithstanding, note that October 1 is the start date of the “marketing” or “discussion” of MA plans. On this date, MA producers can market plans for the annual election period even though the plans may not be written until the dates indicated. Some of the problems in the marketing of MA plans came about from marketers (producers) working outside of the guidelines and attempting to enroll prospects outside of the legal enrollment dates. Voluntary DisenrollmentA person may choose to end his or her membership in a Medicare Advantage plan for any reason, but only during one of the election periods—annual, MADP, or special. Beginning in 2012, a person may disenroll from an MA plan to enroll in one of the Medicare-rated “five-star” plans at any time of the year. An individual who wishes tovoluntarily disenroll should write a letter or complete a disenrollment form and send it to his or her plan’s customer service department. The date of one’s disenrollment depends on when the plan receives the written request to disenroll. In general, written requests to disenroll must be received by the Medicare Advantage plan no later than the tenth of the month to be effective the first of the following month. Written requests to disenroll that are received after the tenth of the month will be effective the second month after the request is received.
An exception to this general rule is that disenrollment requests received between November 1 and November 10 are usually effective December 1. However, because the month of November is also the annual election period, one can ask for a January 1 effective date.
Even though a person has requested disenrollment, he or she must continue to receive all covered services from the plan’s contracting medical providers until the date the disenrollment is effective. The individual will be covered by Original Medicare after this, unless he or she has joined another Medicare Advantage plan.
Note that other factors are also involved in voluntary disenrollment. For instance, consider a Medicare beneficiary whose first Medicare enrollment was in a Medicare Advantage program, and within the first 12 months of coverage, decides to disenroll from the program and enroll in Original Medicare. In this situation, he or she has 63 days to purchase any Medicare supplement plan (within the scope of the plans that the carrier offers) on a guaranteed basis.
Also, a person may have originally enrolled in Original Medicare and a Medicare supplement program, then decided to switch to Medicare Advantage—and then decided to switch back to Original Medicare. In this case, the individual may, within 12 months after that decision, go back to Original Medicare and the same Medicare supplement offered by the same MS carrier as before, if he or she has been in the Medicare Advantage plan for less than a year.
A problem that may arise involves Part D coverage. If an enrollee decides to use the one-year guarantee to switch out of Medicare Advantage, CMS rules require the enrollee to complete a stand-alone Part D application and mark the “Special Election Period” box that appears in the “Office Use Only” portion of the application to disenroll from the prescription drug program. CMS will then use the SEP on the Part D application to begin the process for the MA disenrollment and return the applicant to Original Medicare. (This SEP procedure is also available when enrolling into an MA plan when receiving Medicaid assistance or when applying for Medicare disability at any time during the year.)
An individual may voluntarily disenroll during the MADP period (January 1 through February 14) by writing or calling his or her plan (or calling 1-800-Medicare), but a written request for disenrollment may be required. The MA company must provide a disenrollment notice within seven days of receiving the request. If the (dis)enrollee wants to return to Original Medicare and obtain a Medicare supplement policy, the Medicare supplement company will require that the new applicant complete the MA questions on the Medicare supplement application and that he or she send a copy of his or her MA plan disenrollment notice, a copy of the letter that he or she sent to his or her MA plan requesting disenrollment, or a signed statement verifying that he or she has requested to be disenrolled from his or her MA plan. If an individual is disenrolling after the February 14 date, a copy of the applicant’s MA plan disenrollment notice will be necessary. Involuntary DisenrollmentA Medicare Advantage plan cannot disenroll a member for any health-related reasons. However, a member in a Medicare Advantage plan may be, or must be, disenrolled from the plan for any of the following reasons:
permanently moving out of the service area;
temporarily moving out of the service area for an uninterrupted absence of more than six months;
losing entitlement or discontinuing enrollment in either Part A or Part B Medicare benefits or failing to pay Part B premiums as required;
filing false or deliberately misleading information during enrollment;
exhibiting disruptive behavior (the plan must first receive permission from CMS to disenroll for this reason);
allowing someone other than the enrollee to use the plan membership card;
failing to pay plan premiums after the plan has notified the enrollee that he or she has a 90-day grace period during which the enrollee can pay the premiums; or
dying.
4.6 - SummaryThis chapter examined the elements of correct and incorrect marketing techniques. It also offered ways to avoid such faulty practices. If you know, remember, and follow the rules established by CMS and your MA companies, you will be successful, and the rewards of satisfactory customer service will follow.
Following is a sample Scope of Appointment as provided by CMS. Many MA/MAPD and PDP plans have been authorized to use modified SOA forms once they have been approved by CMS. These forms normally reflect only the products used by that particular company.
Notice: CMS has also approved a revised version of the SOA form that can be used by plan representatives for companies that do not offer PFFS plans, Medicare Cost plans, or MSA plans. In that version, those three items will be excluded from the SOA form illustrated above.
In addition, this revised SOA form will describe a Medicare point-of-service (POS) plan as “a type of Medicare Advantage plan available in a local or regional area that combines the best features of an HMO with an out-of-network benefit. Like the HMO, members are required to designate an in-network physician to be the primary health care provider. You can use doctors, hospitals, and providers outside of the network for an additional cost.”

2.1 - The Basics of MedicareMedicare is a significant part of the American health care delivery system. Producers who work with seniors and who are intent on providing service as well as products must become familiar with the benefits of the Medicare program as well as its limitations. The required knowledge level for those who market Medicare Advantage and Part D plans specifically is even higher. Understanding the basics of Medicare is necessary for those who sell MA, MAPD, and/or stand-alone Part D plans. Lack of producer understanding of the Medicare program in general and of these plans in particular was the cause of much of the dissatisfaction and unrest with the new MA and Part D programs when they were introduced.
Upon completing this chapter, you will understand:
the basics of Original Medicare;
what Medicare Part A does and does not cover;
what Medicare Part B does and does not cover; and
how each aspect of Medicare—Parts A, B, C, and D—is funded.
2.2 - The Original Medicare ProgramTo understand Medicare Advantage and Medicare Part D, you should first understand the basics of what we now call the Original Medicare program. Medicare Parts A and B represent Medicare’s foundation. Understanding Parts C and D is possible only by referencing these original elements of the program. The Original Medicare program remains strong and viable and is the preferred approach for approximately 75 percent of Medicare beneficiaries. The Basics of Original MedicareAs you’ve learned, the Medicare program originally consisted only of Part A and Part B. Part A covers costs associated with hospitalization and related services; Part B covers physician fees and certain other out-patient services. When the new programs—Parts C and D—were introduced, it became necessary to distinguish the way services are delivered and paid for; hence, Parts A and B were reclassified as a distinct segment of the Medicare program and were identified as Original Medicare.
It is particularly important that the Medicare Advantage producer understand what Original Medicare covers, because that coverage is the foundation of what the MA plan must cover. To be unaware of the basic underlying benefits and coverages that MA plans must provide to match or even exceed the benefits and coverages of Original Medicare is to be derelict in representing Medicare Advantage products. In fact, it may lead to misrepresentation. Unfortunately, such offenses have occurred, and MA companies must assist producers in understanding these basic fundamentals to ensure that their representatives are not caught in the position of engaging in deceptive marketing practices.
Medicare Parts A and B are, and always have been, fee-for-service plans. In other words, Medicare pays a provider based on the fee for the service rendered. These fees (the “allowable charges”) are set by Medicare in advance based on its determination of “reasonable” charges per zip code.
Hospitals, physicians, and other care providers that work with Medicare on this basis are referred to as participating providers. Those who have agreed to accept Medicare’s allowable charge as full payment for the covered service are said to accept assignment. When a Medicare-covered person “assigns” his or her claim to a provider, he or she is effectively assigning the Medicare payment for the service directly to the provider. Medicare Part A CoveragesMedicare Part A helps cover the costs associated primarily with hospitalization. It includes the following expenses:
hospital stays—after the payment of a deductible:days 1 through 60—fully covered by Medicare
days 61 through 90—requires a daily co-pay by the beneficiary
days 91 through 150—requires a (larger) daily co-pay by the beneficiary;
care in a skilled nursing facility—for a certain number of days, within certain requirements and limitations, and only for skilled care. The care must be associated with a prior hospitalization of at least three days, not counting the day of dismissal from the hospital, and the patient must have been “admitted” to the hospital, not classified as “under observation”;
some home health care—again, within certain restrictions and requirements;
hospice care—for a terminal patient, either at home or at a hospice;
blood—a certain number of pints after a three-pint “deductible” received in a hospital or skilled nursing facility during a covered stay; and
some inpatient mental health care.
Medicare Part B CoveragesMedicare Part B helps cover costs associated with outpatient health care and covers the following:
medical and other services, such as:doctor’s services (excluding routine physical exams)
outpatient medical and surgical services and supplies
diagnostic tests
urgently needed care
X-rays, CAT scans, EKGs, lab tests, HIV screenings, and pulmonary rehabilitation
ambulatory surgery center facility fees for approved procedures and outpatient chemotherapy
ambulance transportation for medically necessary services when other transportation would endanger the insured’s health, including air transportation when ground transportation is not available to the closest health care facility
physical, occupational, and speech therapy
durable medical equipment, such as wheelchairs, hospital beds, oxygen, and walkers
medical supplies
second surgical opinions
outpatient mental health care
outpatient physical and occupational therapy, including speech-language therapy;
clinical laboratory services—blood tests, urinalysis, and more;
home health care—within certain requirements and limitations for costs not covered by Part A, and for medically necessary and skilled nursing care or medical social services;
outpatient hospital services—hospital services and supplies received as an outpatient, under a doctor’s care;
blood—pints of blood received as an outpatient or as part of a Part B covered service, with a three-pint deductible and a 20 percent co-pay for additional pints;
prosthetic devices, including artificial limbs and eyes, and their replacement parts, including arm, neck, and leg braces;
kidney dialysis, services and supplies, kidney disease education services, and kidney transplants;
heart, liver, lung, pancreas, intestine, bone marrow, and cornea transplants under certain conditions and when performed at Medicare-certified facilities; and
certain preventive services:bone mass measurements
colorectal cancer screening and abdominal aortic aneurysm screening
diabetes services and supplies and foot exams and treatment for diabetes-related nerve damage and diabetes self-management training
glaucoma screening
mammogram screening and clinical breast exams
Pap test and pelvic examination, including cervical and vaginal cancer screenings
prostate cancer screening
vaccinations—shots for flu (one per season), pneumococcal pneumonia, and hepatitis B
cardiovascular screenings every five years to test cholesterol, lipid, and triglyceride levels
one pair of eyeglasses with standard frames (or one set of contact lenses) after cataract surgery that implants an intraocular lens
certain chiropractic services (subluxation)
medical nutrition therapy services
The Medicare Modernization Act of 2003 added the following preventive benefits to Part B:
a one-time initial wellness physical exam (called “Welcome to Medicare”) within 12 months of the day an individual first enrolls in Medicare Part B;
screening blood tests for early detection of cardiovascular disease;
diabetes screening tests for those at risk of getting diabetes; and
smoking cessation counseling, if ordered by a doctor.
PPACA 2010 further expanded the “preventive” measures of Medicare coverage by
eliminating the deductible and coinsurance amounts for most preventive services;
providing coverage for annual wellness visits, where beneficiaries receive a personalized prevention plan service at no charge;
covering obesity counseling and weight management programs;
providing screening and behavioral counseling interventions in primary care to reduce alcohol misuse;
covering screening for depression; and
covering sexual orientation counseling and screening for sexually transmitted diseases.
2.3 - What Medicare Does Not CoverNearly as important as being able to tell prospects and clients what Medicare covers is the ability to tell them—or forewarn them—of what Medicare will not cover. Health care costs that are not covered include, but are not limited to:
acupuncture
ambulance services (except in emergencies or when the individual’s health would be in danger if other transportation was used)
chiropractic services, except for some limitations
dental care and dentures (with only a few exceptions)
cosmetic surgery
custodial care (help with bathing, dressing, using the bathroom, and eating) at home or in a nursing home
health care while traveling outside of the United States (except in limited cases)
eye care—routine exams, eye refractions, and most eyeglasses
hearing aids, hearing exams, and hearing tests that haven’t been ordered by a doctor
long-term care, such as that delivered in most nursing homes (custodial care)
orthopedic shoes (with only a few exceptions)
outpatient prescription drugs (with only a few exceptions)
routine foot care (with only a few exceptions)
routine physical exams (beyond the annual wellness visits)
screening tests (with some exceptions)
shots (vaccinations—except those approved)
some diabetic supplies (like syringes or insulin unless it is used with an insulin pump)
first three pints of blood
additional charges for a private hospital room
private nursing care
skilled nursing care costs beyond 100 days a year
meals delivered to the home
medical charges billed by relatives
personal comfort items
intermediate care
custodial care
services not considered reasonable or medically necessary by Medicare
Medicare Deductibles and Co-PaymentsIn addition to the specified services Medicare does not cover, additional coverage gaps exist because of the program’s system of deductibles and co-payments. Medicare was designed to be a cost-sharing program. It requires the participant to assume a portion of the cost of his or her care. For example, an individual entering the hospital must pay a “per benefit period” deductible ($1,184in 2013) before Medicare Part A will cover the costs and, if the stay is longer than 60 days, he or she will be required to assume a portion of the daily cost.0F2 (In 2013, the daily cost-share for the recipient is $296 for days 61 through 90 and $592 for days 91 through 150.)
Enrollment in Part B requires the payment of a monthly premium and, for services covered by Part B, an individual must first pay an annual deductible ($147 in 2013) before Medicare will provide any benefit. In addition, for each covered Part B service, the enrollee may have to share a portion of the cost (typically 20 percent), depending on the service provided.
Medicare’s deductibles and co-payments are subject to increase every year. As Medicare is used by an even greater number of recipients, and as the general cost of hospitalization and medical care rises, it is fairly certain that these amounts will, in fact, increase. It is important to understand that even though a Medicare Advantage plan must cover what Medicare covers, there is no relationship between the deductibles and co-payments associated with Original Medicare and those charged by Medicare Advantage programs. Original Medicare’s deductibles and coinsurances are entirely different from those of MA plans. Each MA plan will have its own deductibles and co-payment amounts, and variations between plans may be great. The astute MA producer must point out to prospects that they are not dealing with Original Medicare, but indeed, an MA plan, which will reflect different deductibles and co-pays than Original Medicare. Answers to Client QuestionsProducers must be prepared to answer any number of questions that prospects and clients may have about Medicare and, as noted, must have a fundamental understanding of the Original Medicare program to properly and accurately present a Medicare Advantage plan. Producers must take full advantage of the educational and training materials offered by their companies, as well as the publication “Medicare and You,” updated and available every year from Centers for Medicare and Medicaid Services as a printed document, or from its Web site at www.Medicare.gov.
2 Under Original Medicare, a benefit period is the measure of an individual’s use of hospital or skilled nursing care services. It begins the day the person enters the hospital or skilled nursing facility and ends once he or she has received no in-patient care for a continuous 60 days.
2.4 - How Medicare Is FundedThe answer to “How is Medicare funded?” may seem complicated, but in reality, it is not. Even with the addition of Medicare Part D, the basics are fairly simple. Following is a brief explanation of how the funding for each part of the Medicare program is derived. Part A—Hospital Insurance (HI)Part A Hospital Insurance (HI) is financed largely from payroll taxes paid by workers and their employers. These taxes are withheld from workers’ paychecks—from each worker’s paycheck, 1.45 percent is deducted to help fund this program. The employer pays the same amount per each employee. Thus, for every $100 an individual earns, $2.90 is “contributed” to the federal HI Trust Fund. Monies paid into this fund are used to cover the costs and benefits associated with Medicare Part A.3 Unfortunately, the strength and stability of the HI Fund are of concern to many as the swell of baby boomers enters retirement, as medical costs rise, as current Medicare expenditures continue to erode the fund, and as the “pay ahead” concept drifts toward a “pay as you go” proposition. Part B—Supplementary Medical Insurance (SMI)Part B Supplementary Medical Insurance (SMI), the medical expense portion of Medicare, is financed primarily by general revenues appropriated by the U.S. government. Another portion is paid by Part B recipients through monthly Part B premiums paid into the program. Traditionally, the Part B funding has been on a 75/25 basis, with SMI general revenue allocations covering about 75 percent of the program’s costs, and the recipients paying about 25 percent of the costs. As costs of medical care rise, so do the Medicare Part B premiums. Part B premiums have risen significantly during the early part of the decade. In 2000, the basic monthly premium was $45.50; by 2013 it had climbed to $104.90. Those whose incomes are greater than certain thresholds pay more. Part C—Medicare Advantage (MA)Funding for Medicare Advantage plans comes directly from Medicare in the form of lump-sum payments to the plan. The payment is based on a “capitated” payment formula, using benchmark levels for services in each county in America. Simply put, in exchange for providing Medicare services, the MA plan receives a monthly per-enrollee payment from Medicare. Enrollees must continue to pay their Part B premium, unless they qualify for an MA plan that covers it.
Benchmark levels are the amounts that Medicare will pay a plan in a specific geographic area, based on Medicare’s fee-for-service schedules and definitions of “reasonable” costs for services. The MA company may then bid to provide services at a cost above or below the benchmark level. The plan bid is the cost at which the plan is willing to deliver Part A and Part B services to each of its enrollees. (Most MA organizations bid below their benchmark level.)
If a plan’s bid is above the Medicare benchmark, enrollees must pay the difference in the form of a base premium. If a plan’s bid is below the benchmark, 75 percent of the difference (the “rebate”) must be passed along to plan enrollees in the form of cost sharing or premium reductions or increased covered services. (The extra 25 percent is retained by the federal government.)
The term capitated comes into play when the benchmark allows for increasing anticipated expenses for the MA company due to the advanced age or chronic conditions of each enrollee. It is significant to note that an enrollee cannot be declined on an MA application because of pre-existing conditions. Therefore, the MA company must be allowed to receive additional monies from Medicare for such instances, knowing that the upper limits will be capitated.
To better explain the financing of Medicare Advantage plans, let’s consider a per month example. Assume that MA Plan #1 Company submits a bid of $600—the per capita (or per enrollee) payment for which it is willing to provide Part A and Part B benefits. The benchmark level for Plan #1’s region is $700. The formula for Medicare’s payment to Plan #1 is calculated as follows: Benchmark: $700 Plan #1 bid: $600 Difference: $100 Medicare’s payment to Plan #1: $600 + (.75 x $100): $675 Base premium enrollee must pay: $0
Now assume that MA Plan #2 Company submits a bid of $750. The benchmark level for Plan #2’s region is also $700: Benchmark: $700 Plan #1 bid: $750 Difference: ($50) Medicare’s payment to Plan #1: $700 Base premium enrollee must pay: $50
Again, if the plan’s bid is below the benchmark determined by Medicare, the plan must return 75 percent of the difference to beneficiaries as additional benefits or as a rebate of the Part B or Part D premiums. (This is where part of the funding for Part D premiums in an MA plan that includes Part D comes into play.) If the bid is above the benchmark, Medicare pays the benchmark amount, and the plan is required to charge enrollees the difference between the bid and what Medicare pays.
Medicare pays the MA company directly for the amount of its bid on a per-enrollee, per-month basis. It is then up to the MA company to manage its business affairs and costs—administrative, acquisition (advertising, commissions), claims, profitability, etc.—accordingly.
If the funding from Medicare is sufficient, then the MA company will remain in business. If not, then the company must either
cut extra benefits afforded by MA law (such as dental and vision);
buy time to “rebid” its efforts with Medicare for the next year;
end its contract with Medicare; or
close its doors.
During the early 2000s, these events were not uncommon. Several plans (then known as Medicare+Choice) were dissolved, and their sponsoring companies were forced to close down. This forced about 1.5 million enrollees to return to Original Medicare. As a result, several laws were initiated to protect Medicare recipients and Part C enrollees by allowing them to return to Original Medicare (as well as to certain Medicare supplement plans) on a guaranteed issue basis should their Part C plan or Part C provider close down. This process came to be known as involuntary disenrollment.
In addition, the effect of MIPPA 2008, which required MA plans to provide regional or national networks in their private fee-for-service (PFFS) plans, resulted in subsequent terminations (involuntary disenrollment) for over 600,000 enrollees. In effect, MIPPA 2008 caused many plan providers to terminate their PFFS plans and turn them into PPO plans for plan year 2010. In the meantime, hundreds of thousands of MA enrollees were involuntarily terminated from existing plans. At the end of 2010, a similar event occurred as more providers terminated their PFFS plans. Estimates ran as high as one million enrollees who lost their coverage and had to find another MA plan or go back to Original Medicare. Those people, as “involuntarily disenrolled,” were allowed to return to a guaranteed issue Medicare supplement plan under the 63-day guaranteed issue provision and were also guaranteed the purchase of a stand-alone Part D plan.
Medicare producers should understand that all MA, MAPD, and Part D plans are contracted with CMS for a period of one year. For that reason, MA, MAPD and Part D plans change each year, and when plans change, enrollees can remain with their original plan, or they can switch to another plan during the Annual Enrollment Period (October 15 through December 7). This is not insignificant. All plans must notify each enrollee of any changes that will go into effect for the following year. As many as two million people received notices of change in their plans in 2012. Part D—Medicare Prescription DrugsA Medicare Part D Prescription Drug program, known as a PDP, is available to senior consumers in two ways:
as a stand-alone plan for those who are enrolled in Part A and/or Part B; or
as part of a Medicare Advantage plan, known as an MAPD plan (Medicare Advantage Prescription Drug plan).
A stand-alone plan is an insurance plan offered by private companies that simply covers prescription drugs through a single policy. Alternatively, Part D benefits may also be available with an MA plan as part of its broad managed care benefits. Part D is a voluntary plan, separate and distinct from Part A and Part B.
Part D plans are financed in two ways: (1) by government appropriations created in MMA 2003, and (2) by premiums paid by Part D participants. If prescription drugs are included in an MA plan, the funding for that portion of the plan is a combination of both, because the bidding process of the MA company sets the amount it will receive from Medicare, whether above or below the Part C benchmark level. In turn, as explained earlier, this bid determines whether money is available to the MA company to be used by the company for Part D benefits or premiums.
Producers must understand that the prescription drug plans are private plans, and premiums are based on several factors. The first factor relates to the plan’s deductibles, co-payments, and treatment of the “donut hole” (explained later in the course). Another factor is whether a drug is covered and, if so, under which of the plan’s “formularies” (also explained later in the course). Other factors are name brand and generic drugs and the price differences between the two. All of these factors affect the cost of Part D benefits, whether as a private, stand-alone policy or as part of an MA plan.
The financing of Part D is a combination of both Medicare (government) payments, beneficiary payments and, in the case of MA plans that offer prescription drug benefits, the cost of the plan. In practice, the producer need not worry about such financing formulae. But in fairness to proponents of Part D and to the various financial techniques employed by the program, the first few years of the program have shown financial success. This success must be attributed to the competitiveness of the system—that of several Part D plans competing for “best buys” with the drug industry.
That picture changed after 2011, however, because Medicare finances a larger part of the Part D program, per PPACA 2010. One of the objectives of PPACA was to “close the donut hole” by having Medicare cover an ever-increasing share of the cost of prescription drugs. Under PPACA, the donut hole will be closed by the year 2020, and a straight 25/75 cost-sharing ratio will be in place (i.e., the enrollee will pay 25 percent of the costs; Medicare will pay 75 percent of the costs).
3 An additional Medicare tax is scheduled to go into effect on January 1, 2013. Wage earners will pay an additional .09 percent if their annual incomes exceed certain thresholds ($200,000 for singles; $250,000 for joint filers).
2.5 - SummaryAll producers who represent or sell Medicare Advantage or Medicare Part D must thoroughly know and understand the basics of Medicare. The basis for what a Medicare Advantage plan will and will not cover stems from what Medicare itself will and will not cover. Simply, if Medicare Part A or Part B does not cover an item, the possibility is great that an MA plan will not cover it unless the item is included in the additional benefits of the MA plan. A producer who does not know these basics is destined for difficulty with his or her company and CMS. In addition, a basic understanding of how each program is funded contributes to the producer’s knowledge of how Medicare functions.

IntroductionSince its introduction in 1965, Medicare’s most sweeping changes came about with theMedicare Prescription Drug Improvement and Modernization Act of 2003, otherwise known as MMA 2003. MMA 2003 greatly expanded Medicare, providing individuals with more choices and options for the delivery of their Medicare services. Most notably, MMA 2003 expanded Part C of the program (renaming it Medicare Advantage) and created Medicare Part D—Prescription Drug coverage.
MMA 2003 did not solve all the problems, but it did provide a way for the elderly to pay for prescription medication in a time when rising drug prices were running far ahead of inflation. Those on fixed incomes were faced with a choice of paying for day-to-day necessities and going without necessary but expensive drugs, or paying for the drugs and getting further behind with living expenses. Through Part D, Medicare beneficiaries have broad access to prescription drug coverage.
This benefit notwithstanding, the act was not without its critics. Both the renaming of Medicare+Choice to Medicare Advantage and the nature of the Part D program itself were criticized for a variety of reasons. Medicare Part C established alternatives to the traditional Medicare+Choice programs and the coordinated care approaches of health maintenance organizations (HMOs) and preferred provider organizations (PPOs). Private fee-for-service (PFFS) plans were also introduced. Making the general public uneasy was the fact that Medicare Advantage and Part D were introduced nearly at the same time, and they were also implemented within a relatively short time (two years). Many people were confused about the benefits of Part D and were dissatisfied with the marketing methods of Part C. The confusion and unease has subsided, however, and today, both programs have become standard fixtures in national health care. As such, both programs will continue to be revised and revamped.
In July 2008, Congress enacted the Medicare Improvements for Patients and Providers Act of 2008 (MIPPA 2008). This act provided for general improvements in the Medicare program but more particularly addressed changes to Medicare Advantage and Medicare Part D problems that had surfaced after MMA 2003. Most of the changes dealt with low-income subsidy qualification, private fee-for-service plan restructuring, special needs plans redefinition, physician payments, and Medicare Advantage plan payment reductions. These changes will be discussed briefly in this course.
A significant portion of MIPPA 2008 was dedicated to defining required marketing practices and standards for Medicare Advantage and Medicare Part D plans. The directives that had been passed down from the Centers for Medicare and Medicaid Service (CMS) to Medicare Advantage companies, to Medicare Advantage prescription drug companies, and to “stand-alone” prescription drug plan companies (and their producers) were elevated to legal status, thus increasing the ability for CMS to rely on laws and statutes to prevent marketing problems in MA and Part D solicitations.
Even though MIPPA 2008 corrected much of the marketing abuse problem, CMS distributed further “guidances” during 2008 and 2009. One was the creation of a “Scope of Appointment” form, which all MA and Part D providers and their representatives are required to complete before having any sales meeting or appointment with a prospect. (Scope of Appointment forms are discussed further in Chapter 4, “Medicare Advantage Marketing Guidelines.”) Another important development was the way referrals must now be treated by Medicare Advantage producers. No longer can a representative simply call a referral. The referral must contact the agent, and then a Scope of Appointment form must be completed before the appointment can begin.
Centers for Medicare and Medicaid Service has continued to pass down to Medicare Advantage and Prescription Drug Plan companies additional marketing rules through 2013 and will undoubtedly continue to provide guidances throughout the existence of the two programs. Many of these provisions will be discussed throughout the course.
In March 2010, Congress passed a comprehensive (and, some would say, confusing) piece of legislation titled the Patient Protection and Affordable Care Act (PPACA). Several small changes were made in the Medicare program, with much of the change involving Medicare Advantage and Medicare Part D. Throughout this course, the changes brought about by PPACA as they relate to Medicare will be discussed. One of the more significant changes was the expansion of the star rating system that CMS instituted with regard to Medicare Advantage and Medicare Part D plans effective January 1, 2012. Under the star system, MA and PD plans are assigned one to five stars, based on specific performance measures: five stars represent the highest ranking (“excellent”); one star signifies the lowest rating (“poor”). The purpose is to help consumers in their search for health care plans and options that best suit their needs. Providers that offer five-star plans may market and sell these plans throughout the year, and consumers can opt to make a once-a-year switch to a five-star plan at any time during the year. Plans rated lower than five stars can be sold only during the initial enrollment period or during the annual election period (open enrollment) of October 15 through December 7 in any year.
Course ObjectivesThe purpose of this course is to offer the professional producer a thorough orientation to Medicare Advantage and Medicare Part D Prescription Drug coverage. The course provides a general background of Medicare and covers the specific components of the Medicare Advantage and Part D programs. Knowing and understanding the background of the Original Medicare program will allow you to better understand the programs of MMA 2003. In addition, this course will cover current program law and will identify accepted as well as unaccepted ways of marketing each program.
Upon conclusion of this course, you will be able to
understand the history, purpose, and evolution of the Medicare program;
explain the benefits and limits of the Medicare program;
describe how Medicare Advantage and Medicare Part D plans operate and the benefits they offer;
understand the sales and marketing issues associated with the introduction of Medicare Advantage and Medicare Part D; and
describe how to properly present, explain, and represent a Medicare Advantage and/or Medicare Part D plan.
1.1 - History of MedicareWe lay the foundation of Medicare programs in general and Medicare Advantage and Medicare Part D in particular through a brief historical sketch. With this information, you will understand why a program such as Medicare was needed to help the poor and elderly obtain critical health services, which previously had been unaffordable for many.
Upon conclusion of this chapter, you will be able to
identify the major pieces of national legislation that created and formed the current Medicare system;
understand the naming and renaming of several parts of the program;
understand the creation of Medicare Part C—Medicare Advantage—and Part D—Prescription Drug—plans;
explain the foundation of MMA 2003; and
explain new marketing mandates for those who represent Medicare Advantage and Part D plans.
1.2 - How It All Came AboutWith each decade that passes, Americans are living longer. Increased longevity became the norm around the first decade of the twentieth century. World War I, the Great Depression, and World War II all had an impact on the country’s population patterns. Nobody could have predicted the tremendous surge in population after WWII. Even though we would later identify a demographic group known as “the baby boomers,” major increases in population and longevity were already underway by 1945. An increase in the number of poor citizens and an expanding older population accompanied this growth.
In 1945, President Harry S. Truman recognized a condition common to the poor and the elderly—the inability to obtain medical care—and asked Congress to write a plan of national health insurance legislation. He was unsuccessful in his attempt, but the move was underway. Social Security had been established and was fully operational by the late 1930s. Social Security administrators had begun thinking of adding a medical insurance program to Social Security.
In 1960, John F. Kennedy made the idea a central campaign issue. Upon becoming President, he and Congress moved forward with a package to create a national health insurance program for the elderly under Social Security. Upon his death, his successor, Lyndon B. Johnson, continued with the idea as a part of his “Great Society” program. By 1965, the foundations of Medicare were secured in response to America’s poor and elderly health care needs.
1.3 - A Brief History of MedicareOn July 30, 1965, President Johnson signed into law the Social Security Amendments of 1965. This new law established the Medicare and Medicaid programs to deliver health care benefits to the elderly and the poor. The original Medicare program was initially aimed at providing benefits for those age 65 and older and their dependents. (The plan’s first recipient was Harry S. Truman, whose benefits began on July 1, 1966.) A few years later, through the Social Security Amendments of 1972, the program was extended to those under age 65 who had been disabled for two years and to those with end-stage renal disease. The act’s companion plan, Medicaid, was created to provide health care benefits and assistance to people of low income, regardless of age or disability. The Original Plan: Parts A and BWhen it was created, Medicare consisted of two parts: Part A and Part B. Part A was designed to cover the costs associated with hospitalization. Part B was intended to cover medical expenses, such as physician fees and other outpatient costs. Part A was and remains cost free to qualified recipients. Part B then and now is optional and requires the payment of a monthly premium.
Part A of Medicare was designed as a “pay ahead” program, as was Social Security. Consequently, a hospital insurance (HI) trust fund was set up to be funded through American taxpayer contributions in the form of payroll deductions. Part B would be paid for by those who elected to participate in this aspect of the program through monthly premiums and general tax revenues. Medicare Based on Fee-for-Service ConceptAs originally designed, Medicare was a fee-for-service plan. Under this approach, recipients receive care from any provider they choose who accepts Medicare’s payments, according to a set fee schedule determined by Medicare. The plan was designed to pay only the greater portion of a recipient’s needs; it was never intended to cover the full cost of one’s care. As a result, the plan included various deductibles and coinsurance provisions, which were then (and are today) to be paid for by the Medicare recipient. In addition, other coverage “gaps” existed with Medicare, prompting private insurance companies to design insurance plans to help fill the “gaps.” Thus, the termMedigap was born. This term, still in use today, refers to the same product that insurance companies and producers know as Medicare supplement insurance (or simply “Med supp” insurance). Medicare supplement insurance covers some of the costs that Medicare does not cover, including, for example, coinsurance, co-payments, deductibles, and some preventive care. Managed CareThe delivery of health care began to change in the early 1970s. Health maintenance organizations, or HMOs, became common. These organizations provide health care services through networks of hospitals, physicians, and care providers. Individuals “join” the HMO as members or enrollees by paying pre-set monthly premiums. As a general rule, enrollees are not charged separately for the cost of services when those services are provided; instead, they “cost share” by paying a co-payment for the services they receive. In addition, enrollees are required to receive services from health care providers who are associated with the network. This approach to delivering and funding health care services soon became known as managed care. Managed care embraces the concept of coordinating all health care services an individual receives to maximize benefits and minimize costs.
The Health Maintenance Organization (HMO) Act of 1973 authorized federal Medicare payments to HMOs. In 1982, the Tax Equity and Fiscal Responsibility Act created a more meaningful alliance with Medicare, making it more attractive for HMOs to contract with Medicare. Although the HMO arrangement was originally related to specific HMO hospitals, networks of those hospitals began to emerge in specific geographical areas. Thus, Medicare recipients were now allowed to receive their medical care from a private company rather than through traditional Medicare fee-for-service. Medicare agreed to pay a fixed monthly per-person payment to the private HMO plan. Unlike the fee-for-service approach, where providers bill Medicare directly, providers who operate within an HMO bill the HMO sponsor, which then pays the bills using the funds it receives monthly from Medicare. Prospective Payment ConceptIn 1983, Medicare revised its fee-for-service payment method for hospitals from “reasonable costs” to a prospective payment system. Under this new prospective payment system, Medicare reimbursement rates to hospitals are set and based on a system of diagnostic related groups (DRGs) for inpatient hospital care. This procedure eliminated the handling of millions of paper bills and thousands of man-hours needed to sort out how much to pay. Under the prospective payment system, Medicare pays hospitals based on DRG codes, which correspond to the reasons recipients enter a hospital. In 2008, Medicare revised and expanded the list to include over 700 DRG codes. By 2011, the list had grown to 14,000 codes, and by 2014, the number of codes will be more than 110,000.1 Introduction of Medicare Part CThe Balanced Budget Act of 1997 authorized additional managed care choices for Medicare recipients with the introduction of a new Medicare Part C program (originally Medicare+Choice). The act divided the Medicare program into a number of financing and delivery systems—the “choice” in Medicare+Choice. In addition to HMOs, Medicare Part C plans could include:
preferred provider organizations (PPOs)
private fee-for-service plans (PFFS)
provider-sponsored organizations (PSOs)
high-deductible medical savings accounts (MSAs)
fraternal plans
Choices for managed and coordinated care became common. Individuals now had a wide variety of options for receipt of Medicare-covered services, in addition to the traditional approach of fee-for-service under Parts A and B. The range of plans under “Plus Choice” began to flourish. Plans were allowed to incorporate additional benefits but had to comply with the basic coverages offered through Part A and Part B. In other words, a Medicare+Choice plan had to equal or better the benefits available through Original Medicare.
The Medicare payment procedure for most of these plans was similar to that created by the entry of HMOs into the Medicare arena: payment was made by Medicare to the plan on a monthly per-person basis. Within a few years, enrollment in Plus Choice programs soared to 6 million people. However, cutbacks in payments to the plans caused many of them to go bankrupt or terminate their contracts with Medicare. Nearly 1.5 million people were forced to return to the traditional Medicare program and, if they so chose, Medicare supplement coverage.
In 2001, the administrative name of the Medicare program was changed from the Health Care Financing Administration (HCFA) to Centers for Medicare and Medicaid Services (CMS). You will see references to CMS from that date forward. CMS operates under the Department of Health and Human Services of the U.S. government.
1 The increase in the number of DRGs has had significant impact on hospitals and the many employees involved with properly coding hospital services to ensure compliance with CMS regulations. The problem with proper coding for “admitted” versus “observational” status caused over 1 million people in 2009 to lose the Medicare extended care benefits for skilled care in a Medicare-approved skilled care facility, because they had not been “admitted” to the hospital.
1.4 - Advent of Medicare Advantage and Medicare Part DBy far, the most sweeping changes in nearly 40 years of Medicare came in the form of the Medicare Prescription Drug Improvement and Modernization Act of 2003 (MMA 2003).
In addition to significant material changes affecting the program and its structure, a number of minor adjustments were made to the nomenclature:
The traditional fee-for-service Medicare program, comprised of Parts A and B, was renamed Original Medicare.
The Medicare Part C program, Medicare+Choice, was renamed Medicare Advantage. Medicare Advantage is commonly referred to as MA.
A new name, Medicare Part D, for prescription drug coverage, was introduced.
More new acronyms were introduced, such as “MAPD,” which stands for Medicare Advantage plans that include prescription drug coverage, and “PDP,” which refers to stand-alone prescription drug plans that are sold outside of Medicare Advantage programs.
These nomenclature changes are important to both producers and Medicare clients, because understanding the names and titles is necessary when producers and clients are discussing Medicare. Too many producers of Medicare Advantage products have already been accused of improper marketing techniques, simply because they didn’t know, understand, or use the correct terminology when discussing sales proposals with the public.
Another naming convention to be aware of is Medicare Insurance, which CMS now uses to refer to Medicare Advantage programs. This term reflects the fact that these plans are intended to deliver, at a minimum, all of the benefits that Original Medicare delivers. This terminology distinguishes MA plans from Medicare supplement insurance (Medigap), which supplements Original Medicare. The Import of MMA 2003More important than revising the nomenclature, MMA 2003 brought about several major changes. The most significant was the introduction of Medicare Part D, the voluntary prescription drug benefit plan. With Medicare Part D, Americans have a government-sponsored means to help them pay for the cost of their prescription medicines.
Another substantial change as a result of MMA 2003 was to, in effect, “privatize” Medicare to a greater extent than ever before. For the consumer, MMA 2003 and Medicare Advantage created a new Medicare marketplace by expanding the choices for access to covered services and care. This is in line with a primary objective of MMA 2003, which is to move more Medicare recipients into managed care plans.
An important provision of MMA 2003 was the creation of regional preferred provider organizations (RPPOs) and their inclusion in the Medicare Advantage plan arena. Regional PPOs are similar to ordinary PPOs but are designed to enable people in rural areas (some as large as eight-state regions) to have access to PPO programs similar to their counterparts in localized, urban areas. Before MMA 2003, Medicare Advantage plans were concentrated primarily in urban communities; those in rural areas often did not have access to managed care options.
Another major change came about with a financial incentive for MA companies in the form of increased “benchmark” payments from Medicare, as compared to the payments Medicare would pay under its own fee-for-service formula. Some critics estimate these increases as anywhere from 7 to 12 to 19 percent. By the summer of 2007, the issue had created considerable discussion in Congress, with some members seeking to reduce the payment to MA companies. Private fee-for-service MA companies have been the primary target of this concern.
Another change was the introduction of financial incentives for the nation’s employers to maintain retiree medical plans for those over 65, particularly in the form of prescription drug benefits. The concern that employers would drop retirees from their group medical plans once “stand-alone” prescription drug plans became available was identified early on. Therefore, MMA 2003 included significant financial incentives for employers to continue to provide group coverage, including prescription drugs, to their age-65-and-over retirees. Among these incentives was a 28 percent rebate from Medicare toward the cost of drug coverage; however, the Patient Protection and Affordable Care Act of 2010 eliminated this rebate starting in 2012.
Also with MMA 2003, “voluntary” prescription drug plans and their implementation became a significant aspect of Medicare. Medicare prescription drug plans are sold as either stand-alone plans by prescription drug plan companies or as part of a Medicare Advantage plan. (Part D benefits through a stand-alone plan or as part of a Medicare Advantage plan will be discussed in detail later in this course.) MMA 2003 placed prescription drugs solely in the realm of Part D. Therefore, all benefits relating to prescription drugs were removed from Medicare supplement plans. A Smorgasbord of OptionsAs you can see, the Medicare landscape changed dramatically with MMA 2003. Individuals now have a variety of options for how their Medicare services are covered and delivered. The following graphic, derived from the educational booklet “Medicare and You” published every year by CMS, illustrates these choices: Medicare Improvements for Patients and Providers Act of 2008In July 2008, Congress passed comprehensive legislation designed to correct some deficiencies in MMA 2003. While some aspects of this act made headlines—notably with respect to problems that had surfaced in congressional hearings in 2006 through 2008 regarding Medicare Advantage overpayments and marketing problems—the legislation called for a number of changes in the Medicare program itself. For example:
Low-income Medicare recipients now have greater and easier access to the various Medicare and Medicaid programs designed for them. The act made it easier to qualify for the low-income subsidy (Extra Help) program for Part D prescription drugs and eased the asset test for Medicare Savings Programs that help low-income individuals pay for various out-of-pocket costs not covered by Medicare.
The act extended the authority of special needs plans (SNPs) and called for a moratorium on new SNPs through December 2010. In addition, this legislation made it more difficult for individuals to qualify for SNPs throughout the remainder of the SNP program period and, by extension, made it more difficult for producers to write SNP applications. Starting in 2011, patients had to meet eligibility requirements for a particular SNP. For instance, with a chronic care SNP, the patient must have been medically diagnosed with the chronic condition to enroll. To be eligible for a dual eligible SNP, the patient must have both Medicare and Medicaid. If the patient’s conditions improve, he or she can be disenrolled from the SNP.
The act required implementation of modifications made by the NAIC to standard Medicare supplement policies. This involved restructuring the current policy offerings and their benefits. This new series of Medicare supplement policies was introduced June 1, 2010.
The act required Medicare Advantage private fee-for-service (PFFS) plans to create provider networks for plan year 2011 and beyond and to implement the same quality improvement programs as local PPOs in plan year 2010. This means that a client in an MA PFFS plan can go to any provider who accepts Medicare and accepts the plan’s terms of payment.
The act provided for a graduated higher Medicare payment schedule for mental health benefits.
The act delayed for 18 months a competitive bidding program involving medical supplies and durable medical equipment.
As a practical matter for Medicare Advantage and Part D producers, the effect of the 2008 act was to correct some deficiencies of MMA 2003 regarding the sale and marketing of these plans. Changes that affect MA and Part D marketing are noted in Chapter 4. The Patient Protection and Affordable Care Act of 2010The Patient Protection and Affordable Care Act of 2010 (PPACA) made significant changes to the way medical care is to be delivered in the United States. While most of the legislation deals with myriad health care delivery and payment changes, provisions affecting Medicare were also included. Most of the Medicare changes deal with Medicare Advantage and Medicare Part D. These include the following:
Medicare Advantage payments from Centers for Medicare and Medicaid to Medicare Advantage providers will be lowered.
A new payment structure for MA companies will provide an increase of up to 5 percent for plans that receive four or more stars in the CMS star rating system.
Starting in 2014, MA plans must maintain a medical loss ratio (MLR) of 85 percent (meaning that 85 percent of premium revenue must go toward enrollee benefits).
Starting in the fall of 2011, the open enrollment period for Medicare Advantage and Medicare Part D changed. Previously, this period ran from November 15 through December 30 of every year. Now the period runs from October 15 through December 7 of every year. This open enrollment period is called the “Annual Coordinated Election Period.”
Also starting in 2011, an individual who enrolls in an MA plan may return to Original Medicare and a Part D plan during the first 45 days of the year. This period, previously referred to as the “open enrollment period,” is now called the “Medicare Advantage Disenrollment Period.”
In 2010, Part D enrollees who reached the “donut hole,” or coverage gap, were given a $250 rebate. Beginning in 2011, the Part D donut hole coverage gap will gradually decrease each year until 2020, at which time it will be eliminated. At that point, a straight payment structure of 25 percent coinsurance by the enrollee and 75 percent payment by Medicare will be the standard. Part D enrollees also receive a discount on their drugs while in the coverage gap: as of 2013, the discount is 52.5 percent on brand-name drugs and 21 percent on generic drugs. The full retail price of the drugs will still be applied to the amount enrollees are responsible for paying while in the donut hole, which will move them through the gap more quickly.
Starting in 2011, high-income beneficiaries became subject to a higher premium for Medicare Part D, similar to the way that the Medicare Part B premium for high-income beneficiaries has been in force.
We will cover these and other Medicare provisions of PPACA 2010 in greater detail in later chapters. A chart that itemizes future changes to Medicare due to PPACA is included in the Appendix.
1.5 - SummaryThis brief history of Medicare will help you understand why and how this important American program developed as a necessary entitlement program for the poor and elderly. The term “Medicare” can be considered an umbrella, under which are a number of different and distinct programs: Original Medicare (Parts A and , Medicare Advantage (Part C) and Prescription Drugs (Part D). Each of these programs is a part of the continuum of the needs of American citizens as our population grows older and as extended longevity becomes an even more important part of the American health care scene.